This course is the first course in a five-course US Federal Tax Specialization. It covers and focuses on the U.S. federal tax system as it relates to individuals, employees, and sole proprietors. Key concepts covered include gross income and items that are statutorily included or excluded in it, personal and business expenses that qualify as tax deductions, and the differing tax treatments for employees versus self-employed taxpayers. Unlike many other introductory courses in tax and as part of this course’s comprehensive wrap-up, learners will be provided with practical and tangible experience reporting both income and expenses on the main individual tax return used in the US, Form 1040. If you have enjoyed this course, consider enrolling in our online graduate Accounting program. The University of Illinois at Urbana-Champaign, consistently ranked as one of the nation's top three accounting programs, now offers a master’s in accounting at a very affordable tuition rate and is completely online. The iMSA is a full Master of Accountancy program and students graduate with an MS that is highly recognized. Try an open course or two, then apply for admission into the credit-bearing version as you may be eligible to take credit-bearing courses during the application process. If you are missing any prerequisites for the full degree, you can complete Coursera courses to demonstrate readiness and strengthen your application for the iMSA. For more information on this exciting iMSA online program, refer to this link: https://www.coursera.org/degrees/imsa
Deductions: For vs. From AGI
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Del curso dictado por University of Illinois at Urbana-Champaign
Federal Taxation I: Individuals, Employees, and Sole Proprietors
80 calificaciones
University of Illinois at Urbana-Champaign
80 calificaciones
Curso 1 de 5 en SpecializationU.S. Federal Taxation
De la lección
MODULE 5: DEDUCTIONS AND LOSSES: IN GENERAL
In this module, you will learn about deductions, which is the term used in tax to describe an expense that is allowed to reduce a taxpayer’s tax liability. You will discover what adjusted gross income is, why it is important, and how to calculate it. You will also learn the difference in tax treatments for special types of acitivites, such as hobbies and rentals.
Conoce a los instructores
Matthew HutchensLecturer of Accountancy
Department of Accountancy
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
Welcome back. In the next series of videos,
we'll examine deductions more closely.
First, recall that deductions are essentially
the tax word for expense that can reduce the tax base.
Recall that Section 61 defines income as broadly conceived.
That is, the taxpayer should assume everything is income unless Congress says it's not.
But with deductions, on the other hand,
we should always assume deductions are disallowed.
That is, we cannot reduce income by them,
unless a specific provision permits the deduction.
The courts have generally held that whether and to what extent deductions are allowed,
depends on legislative grace.
That is, what Congress has decided to legislatively
decree what is an allowable expense that can reduce the tax base.
As a result, deductions are defined quite
narrowly and have many rules associated with them.
This is for a good reason since the risk is that
taxpayers might abuse deductions and reduce
their tax base by too much, leaving less money
to the government to fund its operations and investments.
Another important aspect of deductions is substantiation.
This means that the taxpayer has the burden of proof for supporting
whether all deductions claimed on the tax return are legitimate.
To do so, taxpayers must maintain adequate records.
For example, if you're a small-business owner and have
legitimate business expenses associated with travel, hotel, maybe advertising,
it's incredibly important that you keep receipts and the invoices to prove that
these expenses are legitimate in case the IRS decides to audit you or your tax return.
This is the proverbial behavior of sticking all my receipts in a shoe box.
We need these receipts to the extent we want to claim
certain deductions and must substantiate the legitimacy for those deductions.
So let's look back at the income tax formula.
We've already discussed gross income, and so the first set of deductions we'll look at is
called deductions for adjusted gross income, or deductions for AGI.
These deductions are subtracted from gross income to then yield adjusted gross income.
Recall that this subtotal, AGI, is very
important because it determines floors and ceilings in
terms of the amount of many other deductions that we'll
see later that can be claimed on a taxpayer's tax return.
AGI also affects the size of tax credits that can be claimed as well.
As a result, we need to make sure we can identify
the right expenses as deductions for AGI.
Broadly speaking, what are deductions for AGI?
Because they're subtracted from gross income to determine adjusted gross income,
they're also called above-the-line deductions, or above AGI.
These expenses can be deducted even if a taxpayer does not itemize.
That is, even if a taxpayer takes the simple standard deduction
and does not keep track of itemized deductions, like medical expenses
or donations to charity.
If a taxpayer does itemize,
then the for-AGI deductions will determine
the size of some of those itemized deductions.
For example, medical expenses are deductible only to
the extent they exceed 7.5 percent of AGI.
So specific to the actual deductions for AGI,
they can essentially be placed into two broad categories.
The first is expenses related to business activities,
whether they're direct or indirect expenses.
This includes business expenses related to running
a business as a sole proprietor or a partner in a partnership.
For example, sole proprietor expenses are reported on the form 1040,
schedule C. Expenses related to partnership business activities or rental activities are
reported on schedule E. Moving
expenses is indirectly related to business activities since
the deduction is only allowed if you meet certain rules about
the distance you move relative to your old versus new job,
as well as the time you work at your new job.
The second category is expenses that subsidize specific activities.
For example, paying alimony,
paying for education-related tuition and fees,
paying interest on a student loan, or contributing
funds into a traditional Individual Retirement Account, or IRA.
These are all activities that Congress has deemed to deserve a deduction that
offsets gross income and, thus, they lower the individual's tax base.
So, after subtracting for-AGI deductions from
gross income and yielding adjusted gross income,
the taxpayer has the choice to deduct the greater of either itemized deductions,
also known as from-AGI deductions, or the standard deduction.
We've already discussed the standard deduction in a previous video,
so let's focus on from-AGI deductions here.
If the taxpayer selects to deduct itemized deductions,
he or she has to report them on schedule A of the form 1040.
From-AGI deductions here include medical expenses to
the extent they exceed 7.5 percent of AGI.
State and local taxes up to a $10,000 cap.
For example, the income taxes I pay to the state of Illinois are
a deduction on my federal tax return up to the cap.
Contributions to qualified charities--
for example, the American Red Cross or American Cancer Society.
Gambling losses and some types of
personal interest expense, such as home mortgage interest and investment interest.
And personal casualty losses, but only if they are
attributable to a federally declared disaster area.
Again, note that some AGI thresholds apply in calculating these deductions.
So they may not necessarily be fully deductible after all is said and done.
It's also important to mention Section 212 here.
Section 212 allows deductible treatment for expenses
that are what's known as ordinary and necessary--
that is, related to the production or collection of income; the management, conservation,
or maintenance of property held for the production of
income, and expenses paid in connection with the determination,
collection, or refund of any tax.
So what does this actually mean?
What are some examples here?
Well, IRC, Section 212 allows some expenses to be deductible--
in particular, deductible for AGI,
if there are expenses related to producing rent or royalty income.
For example, you own an office building that you rent out, but you have
some expenses associated with
the office building, like utilities, maintenance, and insurance.
These expenses will be deductible for AGI.
Other examples could be expenses paid to determine
the taxpayer's tax liability related to their business,
rent, royalty, or farming operations.
For example, if a sole proprietor hires an accountant to
calculate the income tax and file the tax return,
the payment made by the sole proprietor for the accountant will be a for-AGI deduction.
So where do trade- or business-related expenses show up on the tax return?
First, their details are reported on schedule C,
E, or F. Schedule C details the profit or loss
from a business of a sole proprietor, or a one-owner business.
It could be a taxpayer's main source of income--for example, a business selling
goods or services. Or it could be a business activity on the side--
for example, if you're a freelance artist or
author on the side or a part-time consultant.
In any of those cases,
you would report the income generated and related expenses on schedule C. The key here,
however, is that the deductions must be directly
connected to generating the income in that business activity.
Schedule E details the income and losses from
other activities, such as from rental properties,
or royalty activities, or for partnerships,
or being a shareholder in what's known as an S corporation.
These types of businesses as well as
a sole proprietorship are broadly known as pass-through entities.
Here the income and expenses are not taxed at the business entity level,
but rather are passed through to the individual owner or
an investor to be taxed only at the individual's level.
Therefore, there is only one layer of tax.
Contrast this with a typical C corporation,
think Microsoft or Ford Motor Company,
with a corporation pays
an entity level tax, but then when it distributes dividends to their shareholders,
the shareholders pay tax on the dividend income as well.
People refer to this structure as the double taxation of corporate income.
But what gets reported on schedule C and E is
income and losses from pass-through businesses.
In fact, profit and losses from farming reported on
schedule F also represent pass-through activities.
Here the farmer reports the various income and expenses related to farming,
then reports the net amount on the individual tax return.
For all these activities,
the net amount appears on the face of the form 1040.
In particular, these are the exact spots where
the individual's business income is reported on the individual tax return,
whether it be from schedule C,
E, or F. These net profits or losses are summarized on
the face of the form 1040 to be combined with other income items.
Because expenses associated with these business activities
are deducted before arriving at AGI,
they are all considered for-AGI deductions.
So, in all, in this video we've gone through,
at a very high level,
the distinction between for- and from-AGI deductions,
as well as touched on business-related and investment-related expenses.
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