CHAPTER 6 – INDIVIDUAL DEDUCTIONS

Overview of deductions for individuals

1. Describing the deductions allowed in the computation of taxable income. Taxpayers are only allowed to
deduct expenditures if there is a specific tax law authorizing the deductions (“legislative grace”). Congress
grants many deductions for taxpayers for a variety of reasons. The deductions appear in one of two places
from individual tax formula:
a. Deductions “For AGI” (above the line) are subtracted directly from gross income.
b. Deductions "From AGI” (below the line) are subtracted from AGI.
Gross Income
- For AGI (above the line) deductions
= Adjusted Gross Income (AGI)
- From AGI (below the line) deductions:
(1) Greater of:
(a) Standard Deduction
(b) Itemized Deductions
(2) Qualified Business Income Deduction (QBID)
= Taxable Income
x Tax Rate_________
= Income Tax Liability
+ Other Taxes______
= Total Tax
- Credits
- Prepayments (withholding, estimated payments, etc.)
= Tax due or (refund)
2. Deductions for AGI are generally “preferred” over deductions from AGI. Deductions FOR AGI help to
indirectly reduce AGI, resulting in tax benefits by making the payer seem less high-income. Whereas FROM
AGI, itemized deductions will have no effect on taxable income (unless taxpayer total itemized deductions
exceed standard deduction).
3. When analyzing a deduction, first determine if expense is deductible. Next, determine location of the
deduction (for or from AGI).
4. Distinction between FOR and FROM AGI deductions does not exist for business entities (C-Corp, S-Corp,
Partnerships). This is ONLY an individual tax concept.
Deductions for AGI. §62. (all deductions listed below – there are many)
Congress generally allows three categories of deductions for AGI:
1. Deductions directly related to business activities.
2. Deductions indirectly related to business activities
3. Deductions subsidizing specific personal activities.
1. Deductions directly related to business activities (5 types) – Taxpayers can deduct expenses incurred to
generate business income. Activities are either profit-motivated or motivated by personal objectives. Profit-
motivated are classified as either (1) “trade or business” activities or (2) investment activities. Trade or
business activities require a relatively high involvement or effort from the taxpayer, whereas investment
activities do not. Investment activities involve investing in property for appreciation or for income payments.
a. Trade or Business expenses (§162) must be:
1. Directly connected to business activity.
2. Ordinary and necessary for the activity (example, appropriate and helpful for generating a profit).
3. Reasonable in amount (not extravagant).
4. Expense reporting:
 Expenses are claimed on Schedule C.
 Revenues from the same activity are also reported on the same Schedule C.
 Net income or loss from Schedule C is transferred to Schedule 1, line 3, and then combined with
other items and included on Form 1040 (page 1), line 8.

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Example 1: Trade or Business expenses
Aaron is a self-employed CPA, and operates a small tax practice as a sole-proprietorship (legally a PLLC). In 2024,
Aaron incurred the following expenses:
Rent $10,000
12-month tax software subscription $3,500
Continuing professional education conference $750

How much of these deductions can Aaron claim in 2024?

All, $10,000 + $3,500 + $750 = $14,250. §162 expenses

b. Rental and Royalty expenses (production of income activities). §212.

1. Taxpayers are allowed to deduct their expenses associated with generating rental or royalty incomes as for
AGI deductions. Taxpayers report expenses and revenue on Schedule E and transfer the net income or loss
from Schedule E to Schedule 1, line 5, and then combine with other items and include on Form 1040 (page
1), line 8.
2. There are limitations to the deductibility of rental losses
Example 2: Rental and Royalty expenses
Sara and Roger own a cabin in MN that is exclusively used as a rental property. They calculated depreciation totally
$12,000 and incurred insurance costs insurance of $3,000 in 2024. How much of these expenses are deductible in
2024?
All, $12,000 + $3,000 = 15,000. §212 expenses. Note there may be limitation on the deductibility of these
expenses in excess of income.
c. Flow-through entities – Individual taxpayers report their share of income from flow-through entities
(partnerships, S-Corps). Any expenses and losses incurred from the entity are considered pass-
through to the entity owners. Flow-through income and pass-through losses reported on Schedule E
and combined for Form 1040.
d. Losses on the disposition of property
i. Trade or business assets – assets disposed at a loss are allowed to be deducted for AGI
deductions
ii. Capital assets - Individuals with excess current year capital losses over capital gains can
deduct up to $3,000 ($1,500 married filing separately) of the excess capital losses against
ordinary income. Any remaining capital losses must be carried forward to future years. (must
use short term before using long term capital losses).
Example 3: Capital assets
In 2024, Trisha sold Rivian stock for $14,000. She originally purchased the shares for $21,000. How much of the loss
is deductible in 2024?
Amount Realized $14,000
Basis $21,000
Total Capital Loss ($7,000)
Deductible loss is limited to $3,000. The remaining $4,000 can be carried forward to future tax years.
e. Excess Business Losses – when individual has business deductions > business income, there is
loss. There are limits to the deductibility of such losses. After applying these limitations, is a
deductible business loss remains, the loss is subject to excess business loss limitation.
i. An excess business loss for the year = the excess of aggregate business deductions for the
year / (business gross income or gain of the taxpayer + threshold amount).
ii. The threshold amount for 2024 is $610,000 for married taxpayers filing jointly and $305,000
for other taxpayers.
iii. Excess business losses are not deductible but is carried forward
Example 4:
Brian, a single cash method taxpayer, invested 20% in a partnership interest of a start-up company
designing battery technology for electric vehicles. In 2024, the partnership incurred a total net business

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loss of $1,800,000. What is Brian’s allocable share of the partnership loss and how much can he deduct in
2024?
$1,800,000 x 20% = $360,000 to loss passed through to Brian
Deductible loss = $305,000
The remaining $55,000 is carried forward to future tax years.
2. Deductions indirectly related to business activities (6 types)
a. 1. Moving expenses – Members of the armed forces who are on active duty and are required to
move because of a military order or relocation to a permanent change of station are allowed to take
moving expenses. Prior to the Tax Cuts and Jobs Act of 2017, moving expenses incurred while
relocating for a job were deductible but this was eliminated.
b. 2. Self-Employed health insurance - Deduction provides equity with employees who receive health
insurance as a qualified fringe benefit. Self-employed taxpayers are allowed to deduct personal health
insurance premiums paid for the taxpayer, the taxpayer’s spouse, the taxpayer’s dependents, and the
taxpayer’s children under the age of 27 (regardless of whether the child is a dfependent) as a for AGI
Deduction.
i. Exception – Deduction is not allowed if the taxpayer has the option to participate in an
employer-provided health plan. If a spouse if prohibited from participating in a spouse’s
employer plan, the deduction is still allowed.
ii. The self-employed health insurance deduction also reduces qualified business income when
computing QBID.
Example 5:
Carl is self-employed and is single. His only source of income is from his self-employment. In 2024, Carl
purchased health insurance, paying $4,500 in premiums for the year. How much of these premiums are
deductible in 2024?
All $4,500 is deductible for AGI
What if Carl is both self-employed and works as an employee. His employer offer health insurance
coverage through an employer sponsored plan, but Carl elected to purchase health insurance on his own
for $4,500 because it was cheaper?
The $4,500 is does not qualify as a for AGI deduction since Carl had the option to purchase health
insurance through an employer sponsored plan. However, the medical insurance premiums still
qualify as a medical expense for purposes of itemized deductions, subject to the 7.5% AGI
limitation.
c. 3. Self-employment Tax Deduction – self-employed taxpayers are required to pay both the
employee and employer portion of payroll taxes on net self-employment income. Self-employed
taxpayers are subject to 7.65% employee + 7.65% employer = 15.3% tax on amounts under
$168,600. Amounts over that are taxed at 2.9%.
i. Employers deduct the Social Security and Medicare taxes they pay on employee salaries.
Therefore, to offer parity with employers, Congress allows self-employed taxpayers to deduct
½ of self-employment taxes paid. The ½ self-employment tax deduction also reduces also
reduces qualified business income when computing the QBID
d. 4. Deductions for Traditional Individual Retirement Accounts (IRAs) - Taxpayers with earned
income are allowed to deduct contributions to traditional IRA’s are for AGI deductions. For 2024, the
maximum deduction is $7,000 ($8,000 if over the age of 50 at year-end).
i. There are limitations on a taxpayer’s ability to claim a traditional IRA deduction
e. 5. Deduction for Health Savings Accounts (HSAs) – Individuals covered by a high deductible
health plan with no other health coverage can set aside amounts for payment of qualified medical and
dental expenses for the taxpayer, spouse, and dependents
i. For 2024, high deductible health plans have a minimum annual deductible of $1,600 for self-
only coverage ($3,200 for family coverage) and their maximum annual deductible and other
out-of-pocket expenses cannot exceed $8,050 for self-only coverage ($16,100 for family
coverage).

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 ii. Individuals can contribute up to $4,150 for self-only coverage ($8,300 for family coverage) to a
HSA and deduct these contributions for AGI. Individuals age 55 or older at the end of the tax
year may contribute and deduct an additional $1,000 annually ( $5,150 [$9,300 for family
plan]).
iii. Distributions from an HSA are tax free if they pay for qualified medical expenses of the
taxpayer, spouse, and dependents. Otherwise, distributions are taxed as ordinary income (and
subject to an additional 20% tax unless the taxpayer is disabled, age 65 or older, or
deceased).
Example 6:
Courtney (age 35) and is single married. In 2024, they participate in a health insurance plan with a $2,000
annual deductible and out-of-pocket maximum of $7,500. Can she contribute to a HSA? If so, what is her
max contribution for 2024?
Qualifying high deductible plan, Courtney can contribute $4,150 to an HSA in 2024.
What if her annual deductible was $1,000?
No HSA contribution allowed since the plan no longer meets the criteria to be considered a high-
deductible plan.
f.
6. Penalty for Early Withdrawal of Savings (CDs) – Allows a deduction for AGI for any interest
income an individual forfeits to a bank as a penalty for prematurely withdrawing a certificate of deposit
or similar deposit.
3. Deductions Subsidizing Specific Activities
a. Alimony payments (pre-2019 divorce decree) - alimony payments received by a taxpayer are
included in gross income if the payment is pursuant to a divorce decree executed prior to 2019. The
payor of alimony payments is entitled to a for AGI deduction is the payment is pursuant to a divorce
decree executed prior to 2019. Child support payments are not deductible.
b. Deduction for Interest on Qualifying Student Loans - A taxpayer can deduct interest on students
loans whose proceeds were used to pay for qualifying education expenses, which include expenses
paid for the education of person attending a postsecondary institution of higher education. Expenses
include tuition and fees, books, room and board, and other necessary supplies and expenses,
including travel.
i. The maximum deduction for student loan interest is $2,500.
i. The deduction is phased-out once the taxpayer’s modified AGI (MAGI) exceeds certain
thresholds. MAGI is defined as AGI without factoring the student loan interest deduction.
ii. The phase-out range is as follows:
MAGI Deduction
MAGI ≤ $80,000 ($165,000 MFJ) Amount paid up to $2,500
Amount paid up to $2,500, less the
amount paid up to $2,500 times the
$80,000 ($165,000 MFJ) < MAG < $95,000 ($195,000 MFJ) phase-out percentage.

$95,000 ($195,000 MFJ) ≤ MAGI No Deduction

Filing Status Phase-out Percentage

Single or head of household (MAGI - $80,000) / $15,000

Married filing jointly (MAGI - $165,000) / $30,000

Example 7:
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Billy is single and paid $2,250 in interest on qualified student loans. In 2024 his AGI was $65,000. How
much student loan interest can he deduct for AGI in 2024?
All, $2,250 of student loan interest expense is deductible for AGI. No income limitation since AGI is
less than $80,000
What if his AGI was 85,000?
$2,250 – [(85,000 – 80,000) / $15,000] x $2,250 = $1,500

Example 8:
Jeremy and Alyssa Johnson have been married for five years and do not have any children. Jeremy was
married previously and has one child from the prior marriage. He is self-employed and operates his own
computer repair store. For the first two months of the year, Alyssa worked for Office Depot as an
employee. In March, Alyssa accepted a new job with Super Toys Incorporated (ST), where she worked for
the remainder of the year. This year, the Johnsons received $255,000 of gross income. Determine the
Johnson's AGI for 2024 given the following information:
a. Expenses associated with Jeremy's store include $40,000 in salary (and employment taxes) to
employees, $45,000 of supplies, and $18,000 in rent and other administrative expenses.
b. As a salesperson, Alyssa incurred $2,000 in travel expenses related to her employment that were
not reimbursed by her employer.
c. The Johnsons own a piece of raw land held as an investment. They paid $500 of real property taxes
on the property and they incurred $200 of expenses in travel costs to see the property and to
evaluate other similar potential investment properties.
d. The Johnsons own a rental home. They incurred $8,500 of expenses associated with the property.
e. Jeremy paid $4,500 for health insurance coverage for himself (not through an exchange). Alyssa
was covered by health plans provided by her employer, but Jeremy is not eligible for the plan until
next year.
f. Jeremy paid $2,500 in self-employment taxes ($1,250 represents the employer portion of the self-
employment taxes).
g. Jeremy paid $5,000 in alimony and $3,000 in child support from his prior marriage (divorce decree
executed in 2018).
h. The Johnsons donated $2,000 to their favorite charity.

Gross income $255,000

(a) Ordinary and necessary 103,000 Ordinary expenses associated with Jeremy's
business expenses business ($40,000 salary + $45,000 supplies
+ $18,000 rent).
(b) Unreimbursed employment 0 Unreimbursed employee business expenses
expenses are not deductible.
(c) Real property taxes and 0 Taxes are deductible from AGI not for AGI;
investment expenses investment expenses are not deductible.

(d) Rental expenses 8,500 Rental expenses are deductible for AGI even
though they are technically investment or
"production of income expenses."

(e) Self-employed health 4,500 Jeremy may deduct all the costs of his health
insurance insurance because he is not eligible for ST's
health plan.

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 (f) Self-employment taxes 1,250 The employer portion of self-employment
taxes are allowed as for AGI deduction.

(g) Alimony 5,000 Alimony allowed as for AGI deduction. Child

support is not deductible.
(h) Charitable contributions 0 Charitable contributions are from AGI
deductions, not for AGI deductions.
Total for AGI deductions 122,250
AGI $ 132,750 AGI

Deductions from AGI (list starting here): Fall in one of two categories from a policy perspective. (1) personal
expenses subsidizing desirable activities or (2) providing tax relief for taxpayers (whose ability to pay taxes has been
reduced involuntarily). The following are itemized deductions allowed in 2024:
1. Medical Expenses: Qualified medical expenses include unreimbursed amounts paid for medical functions.
a. Common Medical Expenses include:
i. Prescription medication (insulin…), medical aids (eyeglasses, contact lenses, wheelchair…).
OVER THE COUNTER MEDICATION ARE NOT DEDUCTIBLE (Advil, Scar cream…)
ii. Payment to medical care providers and facilities
iii. Transportation for medical purpose (annual cost or standard mileage at $0.21 per mile)
iv. Travel expenses where primary purpose of travel is medical (lodging deductions limited to $50
per night) No vacation elements deductible.
v. Long-term care facilities (some exceptions)
vi. Health insurance premiums (if NOT deducted by self-employed taxpayers)
1. Exception: Health insurance premiums excluded from wages through an employer’s
health insurance plan are not deductible as an itemized deduction.
2. Exception: health insurance premiums paid for on an exchange (Affordable Care Act)
which qualifies for a §36B premium tax credit are not deductible as an itemized
deduction.
vii. Note: Cosmetic surgery is generally not deductible unless the surgery is necessary to
ameliorate a deformity arising from or directly related to a congenital abnormality, a personal
injury resulting from an accident or trauma, or a disfiguring disease.
viii. The lodging and meal costs for stays at a hospital are deductible medical expenses (cost of
lodging and meals at long-term care facilities (e.g., nursing home) is only deductible if the stay
is medically necessary as opposed to for convenience.)
b. Medical Expense Deduction Limitation: itemized medical expense deduction is limited to amount of
unreimbursed qualified medical expenses paid during the year (doesn’t matter when services were
provided) that are excess of 7.5% of AGI. This is known as a floor limitation because amount below
the “floor” are NOT deductible. [total qualified medical expenses – (AGI amount * 7.5%) = deductible
medical expense].
Example 1:
Roger incurred the following medical expenses for 2024.

Doctor office visits $2,000

Emergency room visits $7,000
Physical therapy $ 800
Over-the-counter drugs $ 250
Prescription drugs $ 400

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Rogers enrolled in a high deductible plan through his employer, and paid $2,500 in insurance premium during 2024.
The insurance premiums were excluded from Roger’s gross income. His insurance reimbursed $1,500 of his
emergency room visit, but no other costs were covered. His AGI for 2024 was $100,000. How much of his medical
expenses are deductible from AGI as an itemized deduction?

$2,000 + $7,000 + $800 + 400 = $10,200 - $1,500 reimbursement = $8,700

AGI $100,000
Threshold 7.5%
AGI limit $7,500

$8,700 - $7,500 = $1,200 deductible medical expenses.

2. Taxes: Payment includes amounts withheld (through employer withholding, estimated tax payments, and
overpayments from the prior year tax return applied to the current year taxes). The amount of taxes
deductible as an itemized deduction is limited to $10,000 ($5,000 married filing separately) in 2024. Note: the
$10,000 cap is set to expire at the end of 2025 absent an act from Congress. Individuals may deduct itemized
deductions payments for the following taxes:
a. State, local, and foreign income taxes. (Changes VIA location. Ex – FL and TN have no income tax,
but crazy highs sales tax)
b. State and local real estate taxes on property help for personal or investment purposes
c. State and local personal property taxes that are assessed on the value of the specific property (ad
valorem taxes). ONLY based on VALUE, so if a car is taxed based on weight, it doesn’t count.
Example 2:
Charles has AGI of $75,500 and has made the following payments related to taxes in 2024:

State income taxes $3,000

State income tax refund (applied to this year’s taxes) $800
Real estate taxes on principle residence $1,400
State excise taxes on liquor $300
Automobile registration (based on vehicle weight) $250
Federal income tax withholdings $5,000

How much of his tax payments are deductible form AGI as an itemized deduction?
$3,000 + $800 + $1,400 = $5,200
Excise taxes on liquor, vehicle registration based on weight, and federal income taxes are nondeductible.

3. Interest: Taxpayers can deduct two types of interest as itemized deductions:

a. (1) Home mortgage interest:
i. deduct interest pain on acquisition indebtedness secured by a qualifying residence.
1. Acquisition indebtedness: debt that is borrowed to acquire, construct, or improve a
qualified residence and is secured by the residence. (house is collateral loan). This
includes home equity loans if the proceeds are used to improve a qualified residence
(ex. Kitchen remodel), and the combined value of the acquisition indebtedness do NOT
EXCEED the limits noted below.
2. Qualified residence: the taxpayer’s principal residence or one other resident owned by
the taxpayer.
ii. The amount of deductible interest is limited based on the amount of the loan and when the
residence was acquired.

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 1. Acquisition indebtedness incurred on or before December 15, 2017. Interest deduction
is limited to the interest on acquisition indebtedness up to $1,000,000. The interest on
the portion of the indebtedness that is more than $1,000,000 is not deductible.
2. Acquisition indebtedness incurred after December 15, 2017. Interest deduction is
limited to the interest on acquisition indebtedness up to $750,000. The interest on the
portion of the indebtedness that is more than $750,000 is not deductible.
b. (2) Investment interest: Taxpayers can borrow money and use the proceeds to make investments in
securities (e.g., stocks, bons, options, etc.). This refers to trading on margin. Taxpayers are allowed to
deduct investment interest to the extent of net investment income. Any excess interest is carried
forward to subsequent years.
c. (other types of interest): Interest expenses on debts incurred in connection with a trade or business
are fully deductible as an AGI deduction. Interest expense incurred on credit cards or on loans to
purchase personal-use assets (other the qualified residence) is not deductible.
Example 3: Interest
This year, Major Healy paid $40,000 of interest on a mortgage on his home (he borrowed $800,000 to buy the
residence in 2015; $900,000 original purchase price and value at purchase), $6,000 of interest on a $120,000 home
equity loan on his home (loan proceeds were used to buy antique cars), and $10,000 of interest on a mortgage on
his vacation home (borrowed $200,000 to purchase the home in 2010; home purchased for $500,000). Major Healy's
AGI is $220,000. How much interest expense can Major Healy deduct as an itemized deduction?
$50,000. Major Healy's acquisition debt on his home and vacation home does not exceed $1,000,000 (the
applicable limit on acquisition indebtedness incurred before December 16, 2017). Thus, he can deduct the
$40,000 mortgage interest on his home and $10,000 of mortgage interest on his vacation home. The interest
on his home equity loan is not deductible.

4. Charitable Contributions: taxpayers can deduct contributions of money or property to qualifying domestic
charities as an itemized deduction. Qualified charitable organizations engage in educational, religious,
scientific, governmental, and other public activities (political campaigns are NOT deductible). The amount of
deduction allowed for charitable contributions depends on whether the taxpayer contributes money or
property:
a. Cash Contributions: deductible in year-paid which includes donations by cash, check (mailbox rule),
ETF, credit card charges, and payroll deductions.
i. Travel – can deduct $0.14 per mile for charitable purposes, treated as cash contribution. (if no
pleasure or entertainment is associated)
ii. Service deductions are non-deductible (ex – CPA volunteering to prepare tax returns for low-
income families)
b. Contribution of Property other than Money – deduction depends on property type
i. Capital gain property – is property that if sold would have triggered a long-term capital gain.
The charitable contribution for donated capital gain property is the properties fair market value.
There is a double tax benefit for donating capital gain property in that the taxpayer can deduct
the fair market value of the property and is not required to recognize any gain on disposition.
1. Exception to Fair Market Value - if the donated property is (1) tangible, (2) personal
property (not realty), and (3) unrelated to the charitable organization purpose, then
then the amount of the deduction is limited to the property’s adjusted basis.
ii. Ordinary Income Property – deduction for donated property that would generate ordinary
income if sold is limited to the lesser of (1) the property fair market value or (2) the property’s
adjusted basis. Capital assets that have declined in value are included in this category.
c. Charitable contribution limits – these are subject to ceiling limitation that depends on the type or
property donated and the type of organization receiving the donation. Types include public charities,
private operating foundations, and private nonoperating foundations. Limitation is as follows:

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Apply the A G I limitations in the following sequence:
- Step 1: Determine limitation for the 60 percent contributions, if applicable.
- Step 2: Apply limitation to 50 percent contributions, which is
AGI × 50% minus the contributions subject to the 60 percent limit.
- Step 3: Apply limitation to 30 percent contributions, which is the lesser of (a) AGI × 30% or (b) AGI ×
50% minus the contributions subject to the 50 percent limit and the contributions subject to the 60
percent limit.
- Step 4: Apply limitation to the 20 percent contributions, which is the lesser of (a) AGI × 20%, (b) AGI ×
30% minus the contributions subject to 30 percent limit, or (c) AGI × 50% minus the contributions
subject to the 50 percent limit, the contributions subject to the 60 percent limit, and the contributions
subject to the 30 percent limit.
Excess contributions can be carried forward for five years. After five years the carried forwarded deduction expires
and is no longer deductible.
Example 4
In addition to cash contributions to charity, Dean decided to donate shares of stock and a portrait painted during the
earlier part of the last century. Dean purchased the stock and the portrait many years ago as investments. Dean
reported the following recipients in 2024:
Charity Property Cost FMV
State University Cash $ 15,000 $ 15,000
Red Cross Cash 14,500 14,500
State History Museum Antique painting 5,000 82,000
City Medical Center Dell stock 28,000 17,000
Assume that Dean's AGI this year is $150,000. Determine Dean's itemized deduction for his charitable contributions
this year and any carryover.

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The remaining value of the antique painting $53,500 ($82,000 − $28,500) is carried over to next year subject to the
30 percent of AGI limit.
5. Other Itemized Deductions:
a. Casually losses (losses arising from sudden, unusual, or unexpected events such as fire,
storm, or shipwreck or theft) attributable to a federally declared disaster. Such losses are
limited to a floor of $100 per event, and up to 10% of AGI for all casualty losses.
b. Gambling losses and expenses to the extent of gambling income
c. Casualty and theft losses on investment property.
d. Unrecovered cost of a life annuity at death
Deductions from AGI – STANDARD DEDUCTION – standard deduction is set amount most individuals can elect to
deduct instead of itemizing their deductions. Taxpayers will deduct the greater of the two deduction types.

The basic standard deduction is determined by the taxpayer’s filing status. Taxpayers also get an additional standard
deduction for if they are (1) blind and (2) 65 of older on the last day of the tax year. For example, a single taxpayer
who is blind and 75 would have a total standard deduction of $18,500 ($14,600 + $1,950 + $1,950).

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 - Dependent taxpayers - For individuals claimed as dependent on another return, the 2024 standard
deduction is the greater of (1) $1,300 or (2) $450 plus earned income not to exceed the standard
deduction amount of those who are not dependents.
Example 5:
Stephanie is 12 years old and often assists neighbors on weekends by babysitting their children. Calculate the 2024
standard deduction Stephanie will claim under the following independent circumstances (assume that Stephanie's
parents will claim her as a dependent).
Stephanie reported $950 of earnings from her babysitting.
Stephanie can claim a standard deduction of $1,400, the greater of the minimum standard deduction ($1,300) or
$450 plus her earned income ($950). (950 + 450 = 1,400) 1,400 > 1,300
Stephanie reported $18,000 of earnings from her babysitting.
Stephanie can claim a standard deduction of $14,600, the greater of the minimum standard deduction ($1,300) or
$450 plus her earned income but limited to the maximum standard deduction for her filing status, (single is $14,600
for 2024). Cannot take deduction over the standard.
Qualified Business Income Deduction – Expanded Conversations: the deduction is 20% of the net items of
income, gain, deduction, and loss from eligible business conducted in the U.S. Investment-related items (e.g. capital
gains, capital loss, nonbusiness interest, and dividends), compensation, and guaranteed payments are excluded
from Qualified Business Income (QBI). An eligible business is a flow-through entity (i.e. partnerships, S-
Corporations, and/or sole proprietorships).
1. The Qualified business income deduction is calculated lesser of:
a. 20% of taxpayer’s qualified business income (after wage limitation discussed below), plus 20% of
qualified real estate investment trust (REIT) dividends, plus qualified publicly traded partnership
income or
b. 20% of excess (if any) of taxable income over the taxpayer’s net capital gains (including qualified
dividends).
Some limitations on deductibility of QBI deduction.
2. Specified Service Trade or Business: certain personal service business income is limited to amount of QBID.
This limitation is to prevent taxpayers from converting compensation income to QBI. If the taxpayer receives
pass-through income from a specific services business (any business based on reputation or skill of its
employees, except architecture). The QBID is phased-out by the following taxable income (before QBID
range):
a. Single taxpayers: $191,950 to $241,950
b. MFJ taxpayers: $383,900 to $483,900
c. Application of Phase-out:
i. If a taxpayer’s taxable income is below the phase-out range, all of a taxpayer’s specified
service income all qualifies for the QBID.
ii. If a taxpayer receives specified service business income above the upper-end of the phase-
out range, no QBID may be claimed by the taxpayer.
iii. If a taxpayer receives specified service business income in between the phase-out range, the
service income is QBI to the extent of the following formula:
(taxable income−lower end of phaseout )
Phaseout %=
Phaseout range
(1−Phaseout %)× Sepecified Service Income=QBI
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 d. Note: The W-2 limitation in (B) below applies in addition to the services income limitation
Example 6
Erin (single) is a CPA and runs her practice as a Single Member LLC treated as a sole proprietorship for tax
purposes. This year, Erin’s share of net business income from her CPA Practice is $201,950 (net of the associated
for AGI self-employment tax deduction). The income is qualified business income. Assuming the income from Erin's
CPA practice is her only taxable income and the CPA practice pays enough wages where the QBI wage limitation
does not apply, how much of a QBI deduction can Erin claim in 2024?

201,950 - 191,950
50,000 = 20.0% Phase-out %

QBI 201,950
1- Phase-out % 80.0%
QBI based 161,560
QBI Rate 20%
QBI Deduction 32,312

3. Wage-Based Limitation:
a. Higher-income taxpayers QBID may also be limited based on their share of W-2 wages associated
with QBI. If taxpayer’s income is over $191,950 (single) or $364,200 (MFJ), the taxpayers QBID
cannot exceed the greater of:
i. 50% of the taxpayer’s share of W-2 wages paid by the business, or
ii. The sum of 25% of the taxpayer’s share W-2 wages paid by the business plus 2.5% of the
unadjusted basis of tangible depreciable business property acquired by the business.
b. The wage limit is phased-in ratably over a range of $50,000 for single taxpayers and $100,000 for
MFJ taxpayers. The application of the wage limitation phase-in is as follows:
( taxable income−lower end of phaseout )
i. Phasein %=
Phaseout range
ii. QBID=Base QBID−(QBID∈exess of Wage limit QBID × Phasein%)

Example 7
Steven (single) is an architect and runs her practice as a Single Member LLC treated as a sole proprietorship for tax
purposes. This year, Steven’s share of net business income from her architecture firm is $400,000 (net of the
associated for AGI self-employment tax deduction). Steven's firm employs one employee who has W-2 wages of
$100,000 and has qualifying property of $150,000. How much of a QBI deduction can Steven claim in 2024?

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 W-2 Wages 100,000
50%
50% of W-2 Wages 50,000 (1)

W-2 Wages 100,000

25%
25% of W-2 Wages 25,000
Qualifying Property 150,000
2.5%
2.5% of Qualifying Property 3,750
28,750 (2)

Greater of (1) or (2) 50,000

QBI 400,000
QBI Rate 20%
QBID before wage limitation 80,000

QBI Deduction 50,000 Wage limited

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 CHAPTER 9 – BUSINESS INCOME, DEDUCTIONS, AND ACCOUNTING METHODS
Legal Classification: When forming a business, taxpayers need to consider what business entity to form.
1. A business entity classified as corporation, limited liability company (LLC), general partnership (GP), limited
partnership (LP), or a sole proprietorship.
2. Legal Classifications:
a. Corporation (Association) —file articles of incorporation
b. LLC —file articles of organization
c. General Partnerships —written partnership agreement
d. Limited Partnerships —written partnership agreement and file a certificate of limited partnership
e. Legal sole proprietors are not required to formally organize their businesses within the state since
the business is not treated as a separate legal entity.
i. A single-member LLC is by default treated as a sole proprietorship for tax purposes but is a
separate legal entity.
f. Note: there are other forms of partnerships, LLCs, and corporations such as limited liability
partnerships (LLP), limited liability limited partnerships (LLLP), professional limited liability companies
(PLLC), and professional corporations (PC). These entities are taxed similarly to the counterparts
mentioned above but have further legal limitations that are beyond the scope of this course.
3. Nontax Considerations:
a. Limitation of liability: Certain business entities protect the owner(s) from being personally liable for
business liabilities (limited liability). Other entity choices do not “shield” the owner from the personal
liability from debts incurred by the business (unlimited liability).
i. Corporations – Owner(s) have limited liability to the corporations’ liabilities.
ii. LLC – Member(s) have limited liability as to the LLC’s liabilities.
iii. Partnerships – General partner(s) have unlimited liability, whereas limited partners have
limited liability to the partnership’s liabilities
iv. Sole Proprietorship – The owner of a sole proprietorship has unlimited liability.
v. Note – limited liability owners can guarantee the liabilities of the business entity and become
liable for business debts.
b. Rights, Responsibilities, and legal arrangements among owners:
i. State corporation laws specify the rights & responsibilities of corporations and their
shareholders.
ii. Shareholders have no flexibility to alter their legal treatment
iii. State partnership laws provide default provisions when partners have the flexibility to depart,
specifying partners’ legal rights and responsibilities for dealing with each other absent an
agreement
iv. Corporations are the only entity type that can IPO (go public). (small exception for limited
partnership in the oil and gas or investment industries)
Business Entity Tax Classification: a business entity’s tax form may be different from legal form. Following is how
tax classifies businesses:
1. General Rule: business entities are generally classified as a taxpaying entity or flow-through (or pass-
through) entity.
2. Taxpaying Entities: DEFUALTS
a. C-Corporations are a taxpaying entity
b. Corporations by default are taxed as C-Corporations (pays tax at flat rate of 21% on taxable income).
c. C-Corporations file form 1120.
d. Corporations can elect to be treated as an S-Corporation and, thereby, be taxed as a flow-through
entity. There is a limitation on which entities are allowed to make an S-Corporation election.
3. Flow-through Entities:
a. The income from “flow-through” entities is taxed at the owner level. That is, the entity does not pay
tax on its taxable income and “flows-through” the taxable income to the owners who pay tax on their
share of business income.

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 b. Unincorporated entities (e.g. LLCs and sole proprietorships) are taxed as partnerships if they have
more than one owner, sole proprietorships if held by an individual, or disregarded entities if held by
some other business entity that is a 100% owner.
c. Partnerships file Form 1065
d. S-Corporation (see above) file form 1120S
e. Sole-proprietorships (technically a disregarded entity) file Schedule C to form 1040
4. Check-the-box regulations: Unincorporated entities may elect to be treated as C corporations. This is known
as the “check-the-box” regulations. Unincorporated eligible entities may elect to become corporations for tax
purposes and elect to become S corporations
simultaneously by filing a timely S corporation
election (they don’t need to separately elect to be
taxed as a corporation first). The election is files
on form 8832.
Gross Income (in general):
1. Gross income for business entities is determined
similarly to individuals. Gross income means “all
income from whatever source derived.”
2. Taxpayers report realized and recognized
income on their tax returns for the following:
a. Receive economic benefit
b. Realize the income
c. Tax law does NOT provide for exclusion
or deferral.
3. Income from a business includes gross profit
from inventory sales (sales – COGS), income
from services provide from customers, and
income from renting property to customers.
4. Certain types of realized income is excludable from gross income (ex: municipal bond interest)
5. (unlike individuals) Businesses are subject to more complex rules & regulations. (some exceptions for small
businesses)
Gross Receipts test for determining Small Businesses:
1. (2024) Small Businesses defined as entity with average annual gross receipts that to NOT exceed $30
million for the 3-year period proceeding the current year:
a. Businesses without 3 years of data use the period when gross receipts are available
b. Gross receipts for short years must be annualized by multiplying by 12 and dividing the results by
number of months in the short period.
2. A business that qualifies as “small” business under a gross receipts test is exempt from certain complex tax
law provisions for each year in which it meets the test.
3. Gross receipts include total sales (net returns and allowances but NOT COGS), amounts received for
services, and income from investments (including tax-exempt interest)
Example 1: XYZ, Inc., a C-corporation, had the following gross receipts for the previous three years:
2021: $24 million
2022: $27 million
2023: $30 million
Is XYZ, Inc. considered a small business in 2024?
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($24+$27+$30) / 3 years = $27 average < $30 million so YES. It is a small business
What if XYZ, Inc. earned $45 million in gross receipts in 2023 instead of $30 million? Is XYZ, Inc. considered a small
business in 2023?
($24+$27+$45) / 3 years = $32 average > $30 million so NO. It is not a small business
What if XYZ was formed on April 1, 2023, and has gross receipts of $23 million through the end of 2023?
23 million*(12 months / 9 month) = 30,666,667 annualized gross receipts > 30,000,000 XYZ is not a small business

Deductions (in general)

1. Legislative Grace – nothing is deductible unless Congress says so. (defined narrowly)
2. Business Deductions – Business expenses are expenses paid or incurred in a trade or business, which are
deductible in full of few limitations.
3. Production of income expenses – expenses paid (or incurred) by individual who is not in a trade or business,
but holds assets for investment purposes.
a. Expenses incurred in production of income activities include investment expenses and other rental
activity. Certain limitations are placed on expenses incurred for production of income.
4. Personal Expenses – Not deductible. Expenses for an individual for personal reasons, not business or
investment reasons.
5. Mixed-use expenses – When an asset may be partially used in business and personal (ex: car). The
expenses associated with the mixed-use asset must be prorated between business use and production of
income use and personal use.
6. What is a trade or business? – To determine whether an activity is a trade or business, there are 2 criteria:
a. (1) Is the activity entered into by the taxpayer meant for earning profit? A profit motive is essential to
operating a trade or business AND
b. (2) Is the activity engages in by the taxpayer on a regular and continuous basis?
- Hobby activities are distinguishable from a trade or business because the activity is not engaged in for
profit, it is engaged in for personal enjoyment. No longer deductible after tax cuts and jobs act.
7. Requirements to deduct trade or business expenses – General rule is that an item is deductible if it is paid or
incurred in the carrying on of a trade or business (provided it is ordinary, necessary, and reasonable)
a. Ordinary – expense that is customary or usual. Expected in the business operation.
b. Necessary – expense that is appropriate and helpful to the business. Incurred for the development of
the taxpayer’s business.
c. Reasonable – expense where amount paid is comparable to similar transactions.
d. Examples:
i. Not ordinary – employer takes employees on a trip to Hawaii where no business is conducted
ii. Not necessary – the officer of the corporation attends a business meeting and brings his
spouse along, who is not employed by the corporation.
iii. Not reasonable - A corporation pays its 100% shareholder’s brother a salary of $250,000,
when employees working in similar positions in other corporations are paid $50,000.
Example 2: Steven operates an accounting firm as a sole proprietorship. During “busy season,” Steven hired
his niece to work as an administrative assistant. From January 2024 to March 2024, Steven paid his niece
$50,000 for her services. A comparable administrative assistant could have been hired for $15,000 during
this timeframe. How much of his niece’s salary can Steven deduct in 2024?

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 $15,000 is deductible in 2024. The remaining $35,000 of the $50,000 salary is nondeductible because the
excess is unreasonable

e.

Limitation of Business Deductions: there are 12 limitation categories.

1. Contrary to Public Policy:
a. Fines and Penalties are not deductible. (fines to government or payments for illegal bribes)
 Legal expenses are deductible if related to the trade or business of the taxpayer.
b. Lobbying and political expenses are not deductible.
Example 3: ABC, Inc., a cash method calendar year C-Corporation, was sued by the EPA and found guilty of
improperly disposing of hazardous materials. The courts ruled that ABC, Inc had to pay a $100,000 fine for violating
EPA regulations. ABC Inc. also incurred $50,000 in legal fees in defense of the litigation. How much of these
expenses can ABC, Inc. deduct?
$100,000 is nondeductible since it’s a fine for a violation of public policy. $50,000 legal expenses are deductible
business expenses. It’s ordinary and necessary (and presumably a reasonable amount) for a business to defend
itself against legal matters
2. Capital Expenditures: must capitalize expenditures for tangible assets that are generally recovered through
depreciation. Also, must capitalize the cost to create or acquire intangible assets that are recovered though
amortization or when the asset is disposed.
3. Expenses associated with tax-exempt income are not deductible because the income associated with the
expense is not included in gross income. Allowing the deduction would be “tax arbitrage” because taxpayers
could borrow money to buy tax exempt assets and generate positive cash flow.
Example 4: Mai, an individual with a marginal tax rate of 37%, borrowed $100,000 at 6% interest and used the
proceeds to purchase tax-exempt municipal bonds. The municipal bonds had a stated rate of 5%. How much of the
interest expense can Mai deduct?

Muni interest income is tax-exempt. The interest expense is nondeductible since the $6,000 interest expense was
incurred to generate tax-exempt interest income. (§265)
4. Accrued to a related party:
a. If 2 taxpayers are related but one uses accrual methos and other uses cash method, an expense
cannot be deducted by the accrual-method taxpayer until income is recognized by cash-method.
b. Sec.267 defines related party as the taxpayer and:
 Certain family members include parents, grandparents, spouse, siblings, children, grandchildren.

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  Entities (like C-Corp) when taxpayer owns more than 50%
 Owners of partnerships or S-corps regardless of ownership %.
Example 5: Sarah, a cash method taxpayer, owns 100% of XYZ Corp., an accrual method C-corporation. Sarah is
also the CEO of XYZ Corp. For her services performed as CEO in 2023, XYZ Corp awarded Sarah a $150,000
bonus payable on February 15, 2024. When can XYZ deduct the bonus expense?

Sarah and XYZ are related parties since Sarah own more than 50% of XYZ Corp. Accordingly, XYZ Corp is
precluded from deducting the bonus in 2022. XYZ Corp. can deduct the bonus in 2024 when Sarah includes the
$150,000 in her income
5. Mixed motive Expenses: (meals and entertainment, transportation, travel)
a. Meals are 50% deductible if directly related to the active conduct of trade or is associated with he active
conduct of a trade or business.
 The 50% disallowance rule does not apply when the meal is treated as compensation or if part of
an employee recreation event
 Directly related means a business activity must clearly take place and the meals expense is
related to the taxpayers business.
 Associated with means the meal precedes or follows a business discussion
 Ex – meals related to business meetings, office and partner meetings, meetings with clients,
meals while traveling for business.
 For years 2021 and 2022 100% of meals are deductible if the expense is not for restaurant
b. Entertainment is nondeductible.
6. Transportation: and traveling one place to another can be deductible with many laws.
a. Transportation costs to and from destination while away from home for business is deductible. (cabs,
planes, airfare)
b. Transportation costs not away from home may be deductible.
 Commuting to work is nondeductible
 Transportation costs between home and a temporary work location are deductible if the taxpayer
has a regular place of business.
 Transportation costs between 2 or more work locations on the same day are deductible
c. Automobile expenses related to business (two methods to compute these deductions)
 Actual Expenses: Keeping all receipts of all expenses paid (depreciation, gas, oil, repairs,
insurance, feed) and tracking the total miles driven in the year and the business miles. A written
mileage log must be kept contemporaneously. To determine the expense deduction total
automobile expense are multiplied by business use percentage.
 Standard Mileage Rate: track total miles during the year and business miles. Taxpayer multiplies
business miles driven * standard mileage rate to determine automobile expenses. For 2024, the
standard mileage rate is $0.67 per mile. Written log must be kept by the taxpayer. They can still
also deduct direct transportation expenses like parking and tolls.
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 7. Travel: Expenses incurred while away from home for temporary business travel are deductible. These
expenses include meals (subject to the 50% disallowance rules (100% in 2021 and 2022 if meals are from
a restaurant)) lodging, and transportation costs.
a. Away from home - tax home is the location of the taxpayer’s principal place of employment, regardless
of where the family residence is maintained. Away means that the taxpayer is absent from his or her tax
home overnight or for substantially longer than an ordinary workday so that sleep or rest is required.
b. Temporary absence is employment away from home in a single location that is expected to last for no
more than a year. (Assignments of over a year are not temporary, so travel costs are no longer
deductible. If the length increases to over a year, the employment is temporary until the date expected
length of the assignment changes.
c. Combining business with pleasure travel.
 Domestic travel within the US – if the trip is primarily for business (more business days than
personal), the transportation expenses are deductible (not deductible if primarily for pleasure).
Meals, lodging, and other expenses must be allocated between business and personal days. (not
– if taxpayer remains in a temporary location to reduce overall costs, the costs for additional days
are deductible).
Example 6: Brittany traveled to Chicago for a conference relating to her work. The conference was a total of 4 days.
While in Chicago Brittany also decided she would visit her old college friend for 2 days. While in Chicago, Brittany
stayed in a hotel. How much of the below expenses can Brittany deduct as travel expenses?
4 business days (4/6) 67%. 2 personal days (2/6) 33%. Predominately business trips. Therefore, 100% of the airfare
is deductible. $1,000 total deductible

 Foreign travel outside the US – Transportation expenses are allocated between business and
personal unless the taxpayer is away for 7 days or less than 25% of the time is for personal
purposes.
Example 7: Aaron was required to travel to Oslo, Norway, for work. His trip was a total of 10 days. He spent 7 days
meeting clients and spent 3 days sightseeing. Aaron consumed all his meals at restaurants. How much of the
following travel expenses can Aaron deduct? $2,730 is deductible.

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 8. Expenses not properly sustained: The taxpayer must maintain adequate records that document: (1) the
amount of the expense; and (2) its business purpose. Records that may substantiate an expense include
receipts, canceled checks, and paid bills.
a. Under the Cohan rule, a court may allow an unsubstantiated expense if the substantiation is not
available at the time of an audit, but it is clear the taxpayer incurred or paid the expense.
b. Travel, meals, gifts, and automobile expenses require more stringent substantiation.
 If the expense is for travel, entertainment, gifts or automobile expenses, the substantiation could include
diaries, trip sheets, travel logs, paid bills, receipts, account books, and expense reports.
 Items that need to be documented include:
1. the amount of the expense.
2. the time and place of the expense or the date and description of the gift.
3. business purpose of the expense; and
4. the business relationship of the person being entertained or receiving the business gift.
c. The Cohan rule is not available for unsubstantiated travel, entertainment, gifts, and automobile expenses because
of the more stringent substantiation standard.
9. Bad debt expense: an account receivable or other business debt that is owed to the taxpayer and related to
its trade or business. Treatment depends on the method of accounting.
a. Cash-method: no deduction is allowed because the receivable was never included in gross income
b. Accrual-method: for tax purposes, businesses must use the specific charge-off method. An accrual-
method business that includes the receivable in income may only deduct accounts receivable or other
business debts when they are determined to be partially or totally uncollectible.
Example 8: In 2023, ABC LLC, an accrual method taxpayer, reported $2,000,000 in credit sales and an account
receivable balance of $575,000 at the end of the year. ABC uses the % of sales method to estimate bad debts for
GAAP purposes. Bad debt expense is recorded at 2% of credit sales. Accordingly, ABC estimated its bad debt
expense to be $40,000. In 2024, bad debt write-offs totaled $35,000, when the debts were determined to be
uncollectable. What is ABC, Inc.’s bad debt expense for GAAP purposes and what period will it record the expense?
There are no deductions
2023 = $40,000 bad debt expense 12/31/2022 Bad Debt Expense $40,000
2024 = $ - 0 – Allowance for Doubtful Accounts $40,000
What is ABC’s tax deduction for bad debts, and in what period is it recorded
Estimates are not deductible for tax purposes. Must use the direct-write-off method. Tax will deduct bad debts in
the tax year deemed uncollectible.
2023 = $0
2024 = $350,000
10. Insurance premiums to protect business property are deductible. If the business self-insures its assets, no
deduction is allowed until the business suffers a loss. Group term life insurance premiums paid on employees
are deductible, but life insurance premiums for key officers are not if the business is the beneficiary.
11. Expenses of an illegal business: illegal payments are not deductible. Legal expenses are deductible even
though they are related to illegal activity. (Exception – drug dealers can deduct their COGS expenses. All
others are not deductible)
12. Interest Expense: taxpayers cannot deduct interest expense that exceeds its interest income plus 30% of its
adjusted taxable income (EBIT).
a. For tax years ending in 2022 or later, adjusted taxable income is: Earnings before interest and taxes
(EBIT). Taxable income + interest expense - interest income + §199A deduction (QBID) + NOL
carryover = Adjusted taxable income
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 b. Any interest expense that is not deductible is treated as being paid in the subsequent tax year and can
be carried forward indefinitely.
 Exception: not applicable to small businesses. Real property businesses can elect out of 163j if
the business uses the alternative depreciation system.
Example 9: In 2024, OldCo, an accrual method taxpayer, had $100,000,000 in gross income and total deductions of
$98,500,000. Therefore, OldCo’s taxable income is $1,500,000. Included in its taxable income computation are the
following income and expense items:
Interest Expense: $ 850,000
Interest Income $ 50,000
Depreciation: $ 4,500,000
How much of the interest expense can OldCo deduct in 2024? $740,000 is deductible in 2024.

Accounting Periods
- Tax year: Report income on annual basis (tax year):
o calendar year: Jan 1 – Dec 31
o fiscal year: and 12-month period ending on a month that is NOT Dec.
o 52/53 week year: ends on same day of the week each year (last Sunday in Jan)
- Not all tax years are available to all business entity types
o General rule: to choose a fiscal tax year, taxpayer must keep books/ records over period
o Individuals and sole proprietorships use calendar
o C corps can use any three-tax year type
o Flow through entities use same tax year of person owning over 50%

Accounting Methods (Cash or Accrual):

1. Accounting methods determine the tax year in which a business recognizes income or deduction items.
2. Financial and Tax accounting methods:
a. Businesses have incentives to select accounting methods permissible under GAAP that accelerate
income and defer deductions in reporting financial statements.
b. Businesses want to choose accounting methods that will defer income and accelerate deductions.
c. Cash Method: income is reported in the year the taxpayer actually or constructively receives the
income. (see constructive receipt doctrine)
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 i. Note – a cash-method taxpayer who earns interest income on an obligation with a maturity date of
more than one year must report interest income using the accrual method.
ii. Deduction General Rule: Taxpayer reports a deduction when the expense is paid. An expense paid
in check is deductible when the check is mailed, unless the taxpayer has insufficient funds. If a
taxpayer uses a credit card, the date of the credit card charge is the date of the deduction even if the
credit card payment is made in a subsequent year.
iii. Prepaid expenses: cash method taxpayer may deduct prepaid expense in the year paid provided the
prepayment doesn’t create an asset that extends substantially beyond the year. (exception is 12-
month rule, expense must be paid before the end of the tax year following the prepayment and
cannot distort income)
iv. Prepaid Interest is prohibited from deductions.
Example 10: On June 1, 2024, Smith Corporation, a cash method c-corporation, paid $6,000 to lease office space for
the next 12 months (i.e., lease ends May 31, 2025). How much of the prepaid expense can Smith deduct in 2023?

$6,000 deductible
On October 1, 2024, Smith Corporation also paid $3,000 for a 3-year subscription to a monthly trade journal. How
much of the prepaid expense can Smith deduct in 2024? $250 deductible

d. Accrual Method: Income is reported when it is earned. Income is earned when: (1) all events have
occurred that fix the right to receive income, (2) the amount of income earned can be determined
with reasonable accuracy.
i. “all-events test” - Under this, a taxpayer must report income under the accrual method at the earliest
of 3 times: (1) taxpayer performs services or delivers goods (2) payment is due (even if not received)
or (3) payment is received. [Expectations include the deferral rule for advance payments for
services (defer income to next year for service provider) and advance payment for goods (can be
deferred to next year)]. The amount of income also must accurately be determined.
Example 11: On April 1, 2024, ABC Inc., an accrual method taxpayer, sells a 24-month service contract to its
customer providing consulting services. The customer paid the entire $72,000 contract upfront on April 1, 2024. The
services will be performed ratably over the life of the contract. How much income must ABC, Inc., recognize in 2024?
2025? 2026?

22
$72,000/ 24 months = $3,000 monthly income. In 2024, $27,000 will be recognized; 2025, $45,000 will be
recognized because 2026 can be included in 2025 for tax purposes

ii. Businesses using the accrual method to determine taxable income follow rules like GAAP
with two basic differences. INCOME SOONER, EXPENSES LATER (1) Taxable income
requirements are structured to recognize income earlier than GAAP (2) Accruing tax
deduction rules are structured to recognize less as accrued expenses than GAAP rules.
iii. Deduction General Rules: Taxpayer reports a deduction when the expense is incurred. An expense
is incurred when the all-events test has been satisfied and economic performance has occurred.
iv. All-events Test for Deduction – satisfied when (1) all events have occurred to fix liability and (2) the
amount of the liability is determinable (amount is quantified). [No deductions are allowed for
contingent or disputed expenses. Taxpayers can only deduct these expenses when they are actually
paid.
v. Economic Performance – occurs when services are provided, property is provided or as property is
used, or payment is made. Specific requirements for economic performance test differ based on
whether the liability arose from:
- Receiving goods or services from another party: When a business receives goods or
services from another person, the business deducts the expense associated with the
liability when the other person provides the goods or services. (Exception – when a
business pays the liability before the other person provides the goods or services.
Then the business can elect to treat the actual payment as economic performance if it
reasonably expects the other person to provide the goods or services within 3.5
months after payment)
- Renting or leasing property from another party: When a business enters into an
agreement to use property (rent or lease) from another person, economic performance
occurs over the term of the lease. Then the business is allowed to deduct the rental
expense over the term of the lease.
- Providing goods or services to another party: businesses liable
- Certain activities creating payment liabilities: economic performance occurs when the
business pays.

vi. Recurring item exception allows taxpayers to take a deduction earlier than would ordinarily be
allowed under economic performance rules. To deduct an item under the recurring item exception:
 the all-events test must be met by the end of the tax year.

23
  economic performance must occur within 8 1/2 months after the close of the taxable year or the
date the tax return is filed if earlier.
 the liability is recurring in nature (that is it is expected to occur each year); and
 The amount of the liability is immaterial or the accrual results in a better matching of the liability
with its related income than accruing the liability in the taxable year in which economic
performance occurs.
 The recurring item exception does not apply to workers’ compensation or tort liabilities.
Example 13: Jones, Inc., an accrual method, calendar year, C-corporation, offers 3- year warranties on all the
products it sells. On December 30, 2023, a customer of Jones, Inc. submitted a claim for a warranty worth $2,000.
Jones, Inc. performs the warranty service on March 1, 2024. How much of the warranty expense can be deducted in
2023? In 2024?
General rule: All-events test is met in 2023 since the warranty liability is established when the customer submits the
claim. However, economic performance is not met until the warranty is serviced. Therefore, $2,000 is deductible in
2024, when economic performance occurs.
Recurring item exception: The $2,000 can be deducted in 2023 under the recurring item exception. Warranties are
a recurring liability, the all-events test has been met, and economic performance occurs within 8 ½ months of
year-end (Presumably, the $2,000 is immaterial and does not distort taxable income and better matches the expense
to income).
c. What methods of accounting can taxpayers use?
 Individuals and Sole proprietorships use the cash method. Most individuals use a checkbook
which is the record keeping required under the cash method.
 C-corporations (small businesses) may use the cash OR accrual method. C-corporations with
average gross receipts over 3 preceding years must use the accrual method.
 S-corporation generally uses the cash or accrual method.
 Partnerships can elect to use the cash or accrual method. A partnership that has at least one
partner that is a C-corporation must use the accrual method if the average gross receipts of the
partnership over the three previous years exceed $30 million.

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 CHAPTER 7: INVESTMENTS:
Investment Income – General: two key tax characteristics that affect after-tax of return from investments:
1. The timing of tax payments or tax benefits (income shifting strategy)
2. The rate at which investment income or gains are taxed or deductible expenses or losses generate tax
savings (conversion strategy)
Defining Investment income into “buckets”
A. Portfolio income/ loss – Stocks and bonds
a. Investments like capital gain/ loss, dividends, interest, annuities, royalties
b. Taxed at ordinary tax rates (ex – interest) or preferential rates (ex – cap gains, dividends) or tax-
exempt depending on income type.
B. Passive Activity income/ loss – K1’s
a. Investments in flow-through entities which generate operating income or loss, and the investor is not a
material participant in underlying operating activities.
b. Income (gain) is taxed at ordinary rates annually
c. Losses are either deducted annually at ordinary rates or deferred and deducted later at ordinary rates.
i. Depends on investor’s circumstances (basis, at-risk, passive loss limitation)
d. Passive – the investor is not a material participant in the business
C. Active business income/ loss – Partners at accounting firms
a. Income from sources where the taxpayer is a material participant. For individuals, this includes
salaries, self-employment income, and income from flow-tough activities.
b. Operating income is taxed annually at ordinary rates. Losses are generally deductible annually
c. Active – individual is actively part of the business
Portfolio Income – Interest and Dividends: investments provide cash flow through interest or regular dividends
A. Interest (certificate of deposit, savings accounts, corporate bonds, governmental bonds): Taxed at ordinary
rates and recognized based on accounting method.
a. Corporate and treasury bonds:
i. Treasury bonds are exempt from state taxation
ii. Zero-coupon bonds: corporate bonds that do not pay periodic interest payments
iii. Bond discount – bond issued at an amount less that FV
iv. Bond premium - bond issued at an amount more than FV
b. Original Issue discount (OID): [directly from corporation] bonds issues at discount are required to
amortize and recognize the periods amortized as interest income.
EXAMPLE 1
Carol, a cash-method taxpayer, purchased an ABC, Inc. zero-coupon bond on January 1, 2024. The bond was
issued at $37,205, matures in 5 years at a face value of $50,000. The annual yield on the bond is 6%. Given Carol
will not receive any interest payments until maturity, how much interest income must Carol include in gross income
in 2024, assuming semiannual compounding of interest?

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 2024 interest = $2,265.78
c. Original Issue Premium: [directly from bond] The premium is added to taxpayer’s basis in the bond.
Taxpayers can elect to amortize premiums over the life of the bond.
EXAMPLE 2 (in excel) On January 1, Susan, a cash-method taxpayer, purchased a corporate bond at issuance for
$27,028. The bond has a face value of $25,000, a stated rate of 10%, and pays interest semiannually on June 30
and December 31. The bond matures in 5 years and yields 8%. How much interest income will Susan include in her
2024 gross income if she doesn’t elect to amortize the premium?
6/30/2024 interest payment $25,000 x 5% = $1,250
12/31/2024 interest payment $25,000 x 5% = $1,250
$2,500
What if she elects to amortize the bond issuance premium?

2024 interest = $2,155.48

Assume Susan doesn’t elect to amortize her original issuance and holds the bond to maturity. What is her gain/loss
at maturity?
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Proceeds (maturity value) $25,000
Less: Basis $27,028
Long term capital loss ($ 2,028)
d. Market Discount: [secondary market] Bonds purchased for less than the FV. Bond discount is treated
as interest income when a bond is sold.
EXAMPLE 3 - On January 1, 2024, Brian purchased a corporate bond on the secondary market for $97,000. The
bond matures on December 31, 2024, and has a face value of $100,000 and a stated interest rate of 5%. Interest is
paid semiannually on June 30 and December 31. How much interest income will Brian recognize in 2024?
6/30/2024 interest payment $100,000 x 2.5% = $2,500
12/31/2024 interest payment $100,000 x 2.5% = $2,500
$5,000
How much interest income will he recognize in 2025?
6/30/2024 interest payment $100,000 x 2.5% = $2,500
12/31/2024 interest payment $100,000 x 2.5% = $2,500
$5,000 Interest Payments
$3,000 Market discount
$8,000 Total interest income
e. Market Premium: [secondary market] Bonds purchased for more than the FV of the bond. Market
premium is treated the same as original issued premium. If no election to amortize is made the
premium is treated as part of the basis of the bond.
i. Series EE and Series I (US Savings) Bonds: issued at a discount or FV. They are not issued
at a discount and are nor subject to OID. Interest accrued over the period the taxpayer holds
the bond and all accrued interest is included in gross income when bonds are redeemed.
EXAMPLE 4: Carmen purchased a series I bond on January 1, 2024, for $10,000. The bond has an interest rate of
9.5% accrued semiannually on June 30 and December 31. Accordingly, the published redemption value for the bond
is $10,973 on December 31, 2024. How much interest income must Carmen recognized in gross income in 2024?
None – Series EE and I bonds interest is excluded from gross income unless elected to include annually.
When Carmen redeems the bond, she will recognize in all accrued interest in gross income, unless the
proceeds are used for qualifying education expenses.
B. Dividends (direct equity investments in corporate stocks and investments in mutual funds): distributions from
a C corporation out of its earnings and profits. Dividends are included in the gross income of the recipient.
a. Individual: Dividends included in gross income (if qualified). Taxed at preferential rate depending on
income level. (0%, 15%, 20%)
i. Qualified – stock held for 60 days during the 121-day period starting before 60 days before ex-
dividend rate. Non-qualified ordinary dividends taxed at individuals’ marginal rates.
b. C-corporation: Dividends are included in gross income, but corporation may be eligible for a dividend
received deduction. Dividends are taxed at a corporation’s marginal rate.
c. Stock dividend with no option to receive cash in nontaxable. Allocate stock basis among shared
owned after the dividend.

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EXAMPLE 5: Gary purchased 300 shares of Blue Corporation stock on March 15, 2023 for $40 per share. Cary pays
a brokerage commission of $5 per share whenever equity securities are bought or sold. What is Gary’s Basis in Blue
Corporation stock?
Purchase Price $40 x 300 shares = $12,000
Brokerage fee $5 x 300 shares = $ 1,500
$13,500 Basis
On October 25, 2024, Gary sold all 300 shares of Blue Corporation stock for $65 per share. How much gain or loss
will Gary recognize on the sale and what is the character of the gain or loss?
Sales proceeds $65 x 300 shares = $19,500
Brokerage fee $5 x 300 shares = ($ 1,500)
Amount realized $18,000
Basis $13,500
Long-term capital gain $ 4,500
Portfolio Income – Capital Gains and Losses:
A. Capital Assets: Gain or loss results from the sale or any taxable disposition of a capital asset.
a. Capital assets are any asset other than:
i. Inventory and other assets held for sale in ordinary course of business
ii. Receivables for performance of services or sale of inventory
iii. Real or depreciable property used in a trade or business
b. Capital assets include (1) non-business assets – personal use assets (ex – personal-use car,
personal residence…) and (2) investment property (ex – stocks, bonds, mutual funds)
B. Holding Period begins the day after acquisition and ends on date asset is sold
a. Short-term gain (loss) = held for 1 year or less
b. Long-term gain (loss) = held for more than 1 year
C. Formula for Calculating Gain (Loss) from Sales of an Asset: basis is the initial purchase price + costs to
purchase or improve the property:

Sales proceeds (and/or FMV of property received)

Less: selling expenses
Amount realized
Less: Basis (investment) in property sold*
Gain (loss) on sale
D. Sale of capital assets purchased in blocks at different times:
a. Default, first-in, first-out (FIFO)
b. Can elect specific identification. Taxpayers using the specific identification method can choose to sell
high tax basis stock first to minimize gains or increasing their losses on stock dispositions
EXAMPLE 6: Over the past 5 years, Bree has been a believer in Red Corporation, purchasing shares at various
points where the valuation made sense to her long-term investing goals. Bree’s acquisitions of Red Corporation
stock are as follows:

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In 2024, Bree was looking to diversify her portfolio and decided to sell 200 shares of Red Corporation for $100 per
share. Absent any election, calculate Bree’s gain on sale.
Amount realized 200 shares x $100 $20,000
FIFO Basis
6/1/2010 100 shares x $50 ($ 5,000)
7/6/2012 100 shares x $75 ($ 7,500)
Long-term capital gain $ 7,500
What is Bree elected specific identification?
Amount realized 200 shares x $100 $20,000
Specific ID Basis
10/12/2020 200 shares x $95 ($18,000)
Long-term capital gain $ 2,000
E. Capital gains preferential tax rates for long term gains:
a. Long-term capital gains are taxed at 0%,15%, or 20% depending on taxpayer’s filing status and
income levels
b. Unrecaptured gains (gain from sale of real property, MACRS depreciation deduction) is taxed at a
max of 25% (lesser 25% or individuals marginal tax rate)
c. Collectibles are taxed at a max of 28%.
d. Small Business Stock – received at original issuance of shared from a C-Corp with a gross tax basis
in assets both before and after issuance of $50 million with at least 80% of the value used in an active
trade or business. If the individual holds the stock over 5 years, they may exclude gain on the sale
based on the date the stock was acquired:
i. After September 27, 2010, exclusion= 100%
ii. Between February 17, 2009, and September 28, 2010, exclusion = 75%
iii. Between August 10, 1993, and February 18,2009, exclusion = 50%
iv. Any gain not excluded under section 1202 is taxed at maximum rate of 28%
F. Capital Gains and losses netting steps:
1. Group capital gains and losses into short-term capital gains and losses and 28% (collectibles and 1202
stock), 25% (unrecaptured 1250 gain), and 0%/15%/20% long-term capital gains and losses (help one
year or less)
2. Net all gains and losses within each of the categories from step 1
3. Offset the net 28% and 25% amounts if opposite signs
4. Offset the results from step 3 against 0%/15%/20% net gain or loss if opposite signs from step 3. If
0%/15%/20% is a net loss, offset the highest taxed gain first.
5. Offset the net short-term net gain or loss against the results of step 4 if opposite signs. The netting rules
offset a net short-term loss against the highest taxed long-term gains first.
Example 1:
During 2024, Ron and Anne sold the following assets:
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*$15,000 of the gain is 25% unrecaptured §1250 gain. The remaining $5,000 is Section 1231 gain taxed as long-
term capital gain subject to the 0/15/20%.
In addition to the capital gains above, Ron and Anne had
qualified dividends of $2,000 and ordinary taxable income of
$100,000. What is Ron and Annes net capital gain or loss
position and gross tax liability?
$12,106 = ($100,000 - $94,300) x 22% + $10,852
$ 2,806 = $13,000 x 22%
$ 300 = $2,000 x 15%
$15,266 Gross tax liability
G. Net Capital Losses: Individuals can deduct $3,000 ($1,500 if married filing separate) of net capital losses per
year. If a taxpayer’s net capital loss exceeds $3,000 for a tax year, the excess is carried forward and added
to the capital losses for individuals never expire.
H. Losses on personal-use Assets: Gains are treated as capital gains based on taxpayers holding period.
Losses are not deductible.
I. Wash sale disallowance rules take place when a taxpayer sells a security at a loss and during the 30-day
period before or after the sale date, the taxpayer purchases the same or “substantially identical” securities to
replace the securities sold.
a. If a taxpayer engages in a wash sale transaction, the loss on the sale of the securities is disallowed
and added to the basis of the replacement securities. The holding period of the shares sold also
carries over to the new shares purchased.
b. The reason is that the economic position of the taxpayer is unchanged, so the loss should be deferred
until the economic position is changed.
c. Disallowance only applies to losses from wash sales, not to the gains,
Example 3: Alice owned 100 shares of Green Corporation stock (adjusted basis of $20,000). She sold 50 shares for
$8,000. Ten days later, she purchased 50 shares of the same stock for $7,000.
What is Alice’s realized and recognized gain or loss?
Amount Realized $ 8,000
Basis $10,000
Realized Loss ($ 2,000)
Recognized loss $ - 0 – purchased within 30 days of date of sale, wash sale rules apply.
What is her basis in the stock after the above transactions?

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Cost $7,000
Disallowed loss $2,000
Basis in new shares $9,000
Investment Interest Expense:
- Borrowing funds to purchase investments result in investment interest expenses
i. Can deduct investment interest expense to extent of income
- Investment Income includes portfolio income taxed at ordinary rates
- investment income includes interest, royalties, annuity income, short-term capital gains and non-qualified
dividends
i. Long-term capital gains and qualified dividends are excluded from investment income
ii. taxpayer can elect to include long-term capital gains and/or qualified dividends in investment income if
they forgo preferential tax rates on these items of income (all or nothing)
- Taxpayers can select which gains and dividends they are electing to include in investment income for
purposes of investment interest expense deduction
Example 2:
Tim borrowed funds to invest in various investments, incurring $1,000 of interest related to the debt. From his
investments, Tim earned $300 in interest income, $400 short-term capital gain, and $500 in qualified dividend
income. How much of the investment interest expense can Tim deduct?
$300 Interest income
$400 STCG
$700 Investment income.
Tim is limited to deducting $700 of the investment interest expense as a from AGI itemized deduction. $300
disallowed investment interest expense is carried forward to next year. Sam can elect for the qualified dividends to
be taxed at ordinary rates to increase his investment income to $1,300, allowing for the entire $1,000 to be
deductible.
Passive Activity Income and Loss:
- Passive activity is “any activity which involves the conduct of a trade or business, and in which the taxpayer
does not materially participate.”
- rental real estate and limited partners are generally considered to be passive participants
- All other participants are considered passive unless their involvement is “regular, continuous, and
substantial.”
- If a taxpayer is a material participant in an activity, the activity is not considered passive. 7 factors for testing:
1. Individual participates in over 500 hours during the year
2. Activity constitutes substantially all participation in such activity by all individuals
3. The individual participates in more than 100 hours during the year, AND the individual’s
participation is not less than any other individual’s participation in activities
4. Activity qualifies as “significant participation activity” (more than 100 hours spent during the
year) and the aggregate of all is over 500 hours for the year
5. Individual materially participated in the activity for any 5 of the preceding 10 taxable years
6. Participated (materially) for any three preceding years in any personal service activity
(personal services in health, law, accounting, architecture…)
7. individual participates on a regular, continuous, and substantial basis during the year.

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 - Passive income: ordinary income form a passive activity is taxable annually as earned
- Passive Losses – ordinary losses may be deducted currently if able to overcome following:
i. Tax Basis Limitation: losses may not exceed investor’s tax basis in the activity. Excess loss carried
over until an event occurs to create more tax basis
ii. At-Risk Limitation: losses may not be over an investor’s amount at risk in the activity. At-risk amount is
calculated like tax basis, except taxpayer may not include investor’s share of debt she is not
responsible to repay. [HOWEVER, usually include investor’s share of mortgage debt secured by real
estate because it is “qualified nonrecourse financing”.] Excess loss carried forward until event occurs
to create additional amount at risk
iii. Passive Loss Limitation: Applied after tax basis and at-risk limitations. Losses form “passive activities”
may only be deducted to the extent that taxpayer has income from other passive activities. If there are
not enough passive income, the passive losses are carried forward until there in enough generated
passive income or the activity is sold. Upon sale, suspended losses first offset any gain from the sale
of the activity, then offset any passive income for the period of sale, and then reduce any nonpassive
income.

Example 4:
Megan a limited partners in ABC, LP and has an adjusted basis in her partnership interest equal to
$50,000. Megan’s at-risk amount is $35,000 ($15,000 of her basis is attributable to her share of
nonrecourse partnership liabilities). During 2024, Megan is allocated a $60,000 of ordinary passive losses
from ABC, LP. Megan also has $25,000 of passive income from other sources. How much of the loss can
Megan deduct under the basis limitation rules?
Tax basis 50,000
Recognized loss (50,000)

Loss suspended under §704(d) (10,000)

Recognized loss (60,000)

$10,000 loss suspended until additional basis acquired.

How much of the loss can Megan deduct under §465 at-risk rules?
At-risk basis 35,000
Recognized Loss (35,000)

Loss suspended under §704(d) (10,000)

Loss suspended under At-risk rules (15,000)
Total Loss (60,000)

How much of the loss can Megan deduct under §465 passive loss limitation?
Passive income 25,000
Recognized loss (25,000)

Loss suspended under §704(d) (10,000)

Loss suspended under At-risk rules (15,000)
Loss suspended under Passive activity rules (10,000)
Total Loss (60,000)

Remaining $35,000 loss is a passive loss. Passive losses can only be recognized
to the extent of passive income. Therefore, of the remaining $35,000 of loss above,
only $25,000 can be recognized under §469.

CHAPTER 8 – OTHER TAXES, TAX CREDITS, AND PAYMENTS

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Individual Tax Formula: again –

Marriage Tax Penalty –

- Marriage penalty: when a married couple ends up paying more in taxes than they would as two individuals
- Marriage benefit: married couple pays less in taxes than they would as two individuals
- Economic / Social implications:
i. Couples may delay or not marry due to tax liabilities
ii. Can influence decisions regarding employment and income (usually if one earns more than the other)

EXAMPLE 1 - Mariage Penalty/Benefit

The following illustrates the marriage penalty/benefit.

Additional Taxes
1. Alternative Minimum Tax (AMT) - parallel tax system designed to ensure that individuals and corporations
pay at least a minimum amount of tax, regardless of deductions, credits, and other tax preferences they might
otherwise claim. The purpose of The AMT aims to prevent high-income earners from paying little to no taxes
by limiting the tax benefit of certain income, deductions and credits.

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 a. Overview of AMT - The AMT operates alongside the regular income tax system. Taxpayers must
calculate their tax liability under both the regular system and the AMT and pay the higher amount
b. AMT Tax Formula:

i.
ii. Plus Adjustements:
1. Tax exempt interest from privae activity bonds
2. Real and property taxes deducted as itemized deductions
3. State income or sales tax
4. Incentive stocl option preference (out of scope for this class)
5. Depreciation (AMT requires slower cost-recovery)
iii. Minus Adjustments:
1. State income tax refund recognized as income under tax benefitrule
2. Depreciation (AMT required slower cost-recover)
3. Gain or loss on of assets (difference in AMT depreciation creates different basis for
AMT purposes)
c. AMT Exemption: Exemption phased out 25 cents for each dollar over threshold:

i.
d. Tentative minimum tax computation –
i. 25% on the first $232,600 of AMT base for all taxpayers other than marries taxpayers filing
separately ($116,300, indexed for inflation annually, for married taxpayers filing separately)
ii. 28% on AMT base more than $232,600 for all taxpayers other than married taxpayers filing
separately ($116,300, indexed for inflation annually, for married taxpayers filing separately)
iii. Note: Net long-term capital gains and qualifying dividends taxed at same preferential rates
used for regular tax purposes (generally 0%, 15%, 20%)
e. AMT = tentative minimum tax − regular tax liability

EXAMPLE 2 - In 2024, Nadia is single and has $400,000 of regular taxable income (all ordinary income).
She itemizes her deductions as follows: real property taxes of $7,500, state income taxes of $30,000, and
mortgage interest expense of $40,000 (acquisition debt of $700,000). In addition, she receives tax-exempt
interest of $100,000 from a municipal bond that was used to fund a new business building for a (formerly)
35
out-of-state employer. Finally, she received a state tax refund of $2,500 from the prior year (which is
included in income since she itemized in 2023. Compute Nadia’s alternative minimum tax, if any.

2. Net Investment Income Tax: High-income taxpayers are subject to the Net Investment Income Tax (NIIT)
which is a 3.8% tax applied to certain types of investment income for higher-income taxpayers.
a. Types of income subject to the NIIT:
i. Portfolio income: Interest, dividends, capital gains, annuities
ii. Rental Income (unless part of a trade or business)
iii. Passive activity income
b. Deductions in determining net investment income: taxpayers can deduct an allocable share of
state, local, and foreign income taxes in determining net investment income. (A reasonable method of
allocation is the ratio of net investment income over total AGI)
c. NIIT Threshold:
i. AGI of $250,000 for MFJ taxpayers
ii. AGI if $200,000 for single taxpayers
iii. AGI of $125,000 for married filing separately taxpayers
d. The net investment income tax is 3.8% of the lesser of:
i. Net investment income, or:
ii. Adjusted Gross Income (AGI) more than threshold amount

EXAMPLE 3 – Net Investment Income Tax: Kiyara, single, had $230,000 of AGI in 2024. Her AGI consisted of
$190,000 of salary, $15,000 of interest income, and $25,000 of long-term capital gains. Kiyara also paid
$9,000 of state income taxes in 2024. What is Kiyara’s NIIT for 2024?
Interest Income 15,000
LTCG 25,000
Investment Income 40,000
Allocable state taxes 1,565 =9000*(40/230)
Net Investment Income 38,435 (1)

AGI 230,000
AGI Threshold (200,000) single
Excess AGI 30,000 (2)

Lesser of 1) NII or 2) Excess AGI 30,000

NII TaxRate 3.80%
NII Tax 1,140

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What if Kiyara’s salary was $220,000 and her AGI is $260,000 (i.e., interest and LTCG remain
unchanged)?
Interest Income 15,000
LTCG 25,000
Investment Income 40,000
Allocable state taxes 1,385 =9000*(40/260)
Net Investment Income 38,615 (1)

AGI 260,000
AGI Threshold (200,000) single
Excess AGI 60,000 (2)

Lesser of 1) NII or 2) Excess AGI 38,615

NII TaxRate 3.80%
NII Tax 1,467

3. Self-employment Taxes – Whether Flow-through income is self-employment income depends on the type of
business entity and the owner’s relationship to the entity. S- corporation flow-through income is never
considered self-employment income. Whereas sole proprietorship flow-through income is always
considered self-employment income. Whether partnership flow-through income is considered self-
employment income depends on the partnership form (e.g. GP vs. LP vs. LLC) and/or if the partner is actively
involved in the partnership activities. If flow-through income is deemed self-employment income, the following
self-employment taxes apply:
a. FICA (Social Security)
b. Medicare Tax: self-employed individuals pay both the employer’s share and the employee’s share of
Medicare tax. The Medicare rate is 1.45% for both the employee and employer, so the combined rate
for self-employed individuals on net earnings from self-employment is 2.9%.
c. Combined Self-employment tax rate: The combined self-employment tax rate in 2024 is 15.3% on
the first $168,600 of net self-employment income. The combined rate is the combined FICA (12.4%)
and Medicare (2.9%) tax rates. Accordingly, once a self-employed taxpayer’s net self-employment
income exceeds $168,600, the net self-employment income is only subject to a rate of 2.9%.
d. Net self-employment income: Self-employment income above $400 is subject to self-employment
taxes. Self-employed taxpayers are allowed an upfront payroll tax deduction of 7.65%. Consequently,
self-employment taxes are only applied to 92.35% (100% - 7.65%) of self-employment taxes to arrive
at net earnings from self-employment (i.e. net self-employment income)
e. For AGI Deduction, one-half of self-employment taxes: Owners who pay self-employment taxes
are allowed to deduct one-half of the payroll taxes as a for AGI deduction in computing individual
taxable income.
f. Additional Medicare Tax: In addition to self-employment taxes, the owner’s flow-through income
may be subject to additional Medicare taxes. The additional Medicare tax is 0.9% and the tax based is
the sum of the owner’s net self-employment income plus other compensation earned as an employee
more than the following threshold:
i. $250,000 for MFJ taxpayers
ii. $200,000 for single taxpayers
iii. $125,000 for married filing separately taxpayers

Example 3: Self-Employment Tax - Carl (single) is a 60% partner in C&G partnership. In 2024, C&G
reported $500,000 of taxable business income for the year. Carl is a general partner and is active in the

37
management of C&G. Accordingly, any ordinary income allocated to Carl is treated as self-employment
income. Carl's only source of income is from C&G partnership. What is Carl’s self-employment tax liability?
Partnership Income 500,000
Partnership Interest 60%
SE Income 300,000
92.35%
Net earnings fromself-employment 277,050

Social Secruity Medicare Total SE Tax

168,600 277,050 445,650
12.4% 2.9%
20,906 8,034 28,941

What is Carl’s Additional Medicare tax?

$277,050 - $200,000 threshold = $77,050 * 0.9% = $693.45
Tax Credits: Know the difference between tax deductions and tax credits. A tax deduction reduces your taxable
income, and its benefit is only to the extent of the taxpayer’s marginal tax rate. Conversely, a tax credit directly
reduces the amount of tax you owe. Example - Taxpayer has gross income of $20,000 and is in the 10% tax
bracket. He has an expenditure that qualifies either for a $2,000 deduction or a $2,000 credit:

1. Nonrefundable Tax Credits: a nonrefundable tax credit is a type of tax benefit that reduces tax liability, but
cannot result in a refund if the credit exceeds the amount of tax the taxpayer owes.
a. Child Tax Credit: designed to help families with children to reduce their tax liability.
i. Eligibility – each qualifying child under 17 at the end of the tax year
ii. Credit Amount – claim $2,000 credit for each eligible child
iii. Phase-out – The total child tax credit (combined amount for each eligible child) is
phased out by $50 for each $1,000 or part thereof which exceeds the
following thresholds:

1.
iv. Other Dependent Credit – Taxpayers may claim a $500 tax credit for other qualifying
dependents that do not meet the child tax credit eligibility requirement above. Note, a
qualifying child who is 18 or older at the end of the tax year qualifies for this other dependent
credit. The other dependent credit is subject to the same phase-out threshold above. Also,
social security numbers are not required for the other dependent credit.

EXAMPLE 4: Child Tax Credit

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John and Emily Thompson have three dependent children: Ava, age 18, Noah, age 14, and Lily, age 12. In
2024, John and Emily filed their taxes jointly and reported $425,200 in AGI. What amount of child tax credit
(including other dependent credit) can John and Emily claim in 2024?
Noah (<17 years old) = $2,000
Lily (<17 years old)= $2,000
Ava (≥17 years old) = $ 500
Credit before phase-out $4,500
Phase out = $425,100 - $400,000 = $25,100 / $1,000 = 25.1, round up to 26.
26 * $50 = $1,300 phase-out
Credit before phase-out $4,500
Phase-out ($1,300)
Child Tax Credit $3,200
b. Child and Dependent Care Credit: designed to assist working families with the costs of child and
dependent care.
i. Eligibility –
ii. Credit can cover a % of qualifying expenses, with the maximum % varying on income. The
following are the maximum expenses eligible for credit
1. The total amount of dependent care expenses for the year
2. $3,000 for one qualifying person or $6,000 for two or more qualifying person
3. The taxpayer’s earned income (e.g., wages, salary, net self- employment income).
Married taxpayers must file a joint return
4. Credit Percentage:

Example 5:
Carlos and Maria Garcia have two children: Sofia, age 2, and Mateo, age 2. In 2024, both Carlos and
Maria work full-time, and they send their children to childcare during working hours. The Garcias incur
childcare expenses of $24,000 for Sofia and Mateo in 2024 ($12,000 for each child). Their AGI is
$125,000. What is the Garcia’s child and dependent care credit for 2024?
Max qualifying expenses per child $3,000
Number of children x 2
Total qualifying expenses $6,000

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Childcare percentage (AGI $125,000) 20%
Child and dependent care credit $1,200
c. American Opportunity Tax Credit (AOTC): designed to help students and families offset the costs of
higher education.
i. Eligibility –
1. Based on qualifying education expenses incurred for the taxpayer, the taxpayer’s
dependents, or third parties on behalf of the taxpayer’s dependents. Note, if the
student is claimed as a dependent by another taxpayer, the credit must be claimed on
the taxpayer’s return (even if the dependent paid the expenses)
2. Students must be enrolled at least half-time in a degree or certificate program at an
eligible institution.
3. Must not have completed the first four years of higher education before the tax year in
which the credit is claimed.
4. Must not have been convicted of a felony drug offense
ii. Qualifying Expenses –
1. Tuition and fees required for enrollment or attendance
2. Course materials needed for coursework
iii. Credit Amount – maximum credit is $2,500 per eligible student per tax year. The credit covers
100% of the first $2,000 spent of qualified expenses and 25% of the next $2,000 (up to 40%)
1. The $2,500 credit limit is on a per student basis. So, a taxpayer paying higher
education costs for multiple dependents can claim up to $2,500 for each dependent
iv. Phase out – The AOTC is phased-out pro-rata based on the taxpayer’s AGI over following:

1.

Example 6
Jack and Rebecca Thompson’s daughter, Sarah, is a full-time student at the University of Minnesota
studying biology. Sarah is a sophomore and in her second year of college. The Thompson’s pay Sarah’s
tuition, fees, and books which amounted to $16,500 in 2024. The Thompson’ file their taxes jointly and
claim Sarah as a dependent. Their AGI for 2024 was $135,000. What is the maximum American
opportunity tax credit the Thompson’s can claim in 2024?
First $2,000 of qualifying expenses $2,000 x 100% = $2,000
Second $2,000 of qual. expenses $2,000 x 25%= $ 500
Total AOTC $2,500
How would your answer change if the Thompson’s AGI was $165,000 in 2024?
$2,500 * (165,000 - $160,000) / $20,000 = $625 phase-out amount
Total credit = $2,500 - $625 = $1,875
d. Lifetime Learner Tax Credit: to support students of all ages in acquiring new skills
i. Eligibility – available to any taxpayer who pays qualified education expenses for themselves,
their spouses, or dependents.
ii. Qualifying Expenses – Tuition and fees for courses taken at post-secondary institutions. Unlike
the American Opportunity Tax Credit, the Lifetime Learner Can also apply to non-degree
courses and courses taken to acquire or improve job skills.

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 iii. Credit Amount – maximum credit is $2,000 per tax return regardless of the # of students with
qualifying expenses. Credit is 20% of up to $10,000 of eligible expenses (max $2,000). None
of the credit is refundable.
iv. Phase out – Subject to the same phase-out ranges as AOTC: if AGI is less than the lower $ of
range, no phase out is required. They don’t make enough money, so the government doesn’t
take any of their credit away. The more money you make, the less credits you get.

1.
v. Credit for Certain Retirement Plan Contributions (§25B) - Depends on filing status and AGI.
The lower the income the greater the credit, but $1,000 max.
vi. Credit for Adoption Expenses (§23) – credit of $16,810 in 2024

EXAMPLE 7: Randy is a CPA working as a tax professional. He holds a bachelor’s degree in accounting. To
further his knowledge on the taxation of partnership taxation, Randy enrolled in a graduate tax course at
the University of Minnesota in 2024. Randy incurred tuition costs for the course of $2,500. What is the
maximum Lifetime Learner Credit Randy can claim in 2024 if he files married filing jointly and his AGI is
$145,000?
$2,500 * 20% = $500
No phase-out since AGI less than $160,000 (MFJ)
2. Refundable Tax Credits: reduces tax liability but can result in a refund if the credit exceeds the amount a
taxpayer owes:
a. Earned Income Credit
b. Portion of Child Tax Credit
c. Portion of AOTC
d. Excess FICA withholding
3. Business Tax Credits:
a. Rehabilitation Expenditures (§50) - Credit of 20% to rehabilitate industrial, commercial and certified
historical structures
b. Work Opportunity Tax Credit (WOTC) (§51) - Credit up to 40% of first $6,000 wages paid for first year
of employment eligible employees are those hard to employ, such as long-term welfare recipients, ex-
felons, high-risk youths, summer youths, food stamp recipients and veterans.
c. Research and Development Activities Tax Credit (§41) – Tax credit based on a percentage of
expenditures on "qualified research"
d. Low-Income Housing Credit (§42) - Provides incentive for taxpayers to build affordable housing for
low-income taxpayers
e. Disabled Access Credit (§44) - Enacted to encourage taxpayers to make their small businesses
(gross receipts < $1 million or 30 or less employees) more accessible to the disabled by giving up to a
50% credit (max credit = $5,000)
f. Credit For Employer-Provided Child Care (§45F) - Employers may claim a credit (vs. deduction) for
25% of qualified childcare; total max = $150,000.
g. Credit for Employer-Provided Family and Medical Leave - Credit equal to 12.5% of wages paid to
employees while on family or medical leave
h. Energy Credits - Business credits for ethanol, building and manufacturing energy-efficient homes and
appliances, and producing alternative energy (i.e. wind). Individual credits for home improvements,
solar panels and electric cars.

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 i. Overall Limit on General Business Credits - There is an overall limit on the total amount of business
credits that can be used in a particular year. Any unused amount can be carried back one year and
forward 20 years
Payments: The federal income tax is a pay-as-you-go system. These tax payments are made in the form of
withholdings and/or estimated tax payments. Employers are required to withhold taxes from employees’ wages. If
withholding is insufficient to cover a taxpayer’s tax responsibility, the taxpayer needs to make
quarterly estimated payments. Self-employed individuals have not withheld agent and must make estimated
payments quarterly
A. Estimated Payment Due Dates (based on calendar year)
a. Q1 – April 15th
b. Q2 – June 15th
c. Q3 – September 15th
d. Q4 – January 15th (next yr)
B. Underpayment Penalties - If a taxpayer doesn’t withhold or make the necessary estimated payments
(measured quarterly) the taxpayer is subject to penalties for underpayment. The penalty is the short-term
AFR plus 3 percent. However, there are safe harbors from being subject to underpayment penalties. A
taxpayer is deemed to have sufficient tax payments if they pay in:
a. 90% of their current tax liability
b. 100% of their previous-year tax liability (110% for individuals with Agi greater than $150,000)

Example 8: Bob and Paula estimate their current year tax liability will be $60,000 (AGI $340,000). Their
tax liability last year was $52,000 and they estimate their employers will withhold $50,000 combined for the
current year. Do Bob and Paula qualify for the safe harbor for underpayment penalties? If not, how much
must Bob and Paula increase their withholdings or estimated payments to avoid underpayment penalties?
90% current year = 60,000 * 90% = $54,000 > $50,000 withholding
110% prior year = $52,000 * 110% = $57,200 > $50,000 withholding
Use 110% instead of 100% because AGI of 340,000 > 150,000
Does not meet safe-harbors, should increase withholding or estimated payments by $4,000 to avoid
underpayment penalties (i.e., to meet the 90% current year safe-harbor).

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