ACCT422 – Tax& Zakat Accounting
Chapter 1 – Introduction to the Taxes System in Saudi Arabia; Persons Subject to Income Tax
Article 1: Definitions
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Article 1 includes definitions for use when using interpreting the income tax law
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Each word will carry the meaning beside it unless the context indicates otherwise
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Please refer to the meanings throughout the course
Article 2: Persons Subject to Taxation
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A resident capital company
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A resident non-Saudi natural person who conducts business in the Kingdom
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A non resident who conducts business in the Kingdom through a permanent establishment
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A non resident with other taxable income from sources within the Kingdom
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A person engaged in the field of natural gas investment
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A person engaged in the field of oil and hydrocarbons production
Article 3: Concept of Residency
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A natural person is considered a resident if he meets any of the following conditions:
He has a permanent place of residence in the Kingdom and resides in the Kingdom for a
total period of not less than 30 days
He resides in the Kingdom for a period of not less than 183 days in the taxable year
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A company is considered a resident in the Kingdom during the taxable year if it meets any of the
following conditions:
It is formed in accordance with the Companies Law
Its central management is located in the Kingdom
Article 4: Permanent Establishment
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A permanent establishment of a non resident consists of the permanent place of the non resident’s
activity through which it carries out business, including business carried out through its agent
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The following are considered a permanent establishment:
Construction sites, assembly facilities, and supervisory activities connected therewith
Installations or sites used for surveying for natural resources including drilling equipment
and ships used for surveying
A fixed base where a non resident natural person carries out business
A branch of a non resident company licensed to carry out business in the Kingdom
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A place is not considered a permanent establishment of a non resident in the Kingdom if it is used
for the following purposes:
Storing, displaying, or delivering goods belonging to the non resident
Keep a stock of goods belonging to the non resident for the purpose of processing by
another person
Purchasing goods for the sole purpose of collection of information for the non resident
Carrying out other activities of preparatory nature for the interests of the non resident
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A place is not considered a permanent establishment of a non resident in the Kingdom if it is used
for the following purposes:
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Drafting contracts for signature in connection with loans, delivery of goods or technical services
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Performing any series of activities stated in the above list
Article 5: Source of Income
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Article 5 lists 10 primary sources of income that are considered accrued in the Kingdom
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The place of payment of the income shall not be taken into account in determining its source
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A payment made by a permanent establishment of a non resident in the Kingdom is considered as if
paid by a resident company
Article 6: Tax Base
(a) The tax base of a resident capital company is the shares of non-Saudi partners in its taxable income
from any activity from sources within the Kingdom minus expenses permitted under this law
Sources – Expenses
(b) The tax base of a resident non-Saudi natural person is his taxable income from any activity from
sources within the Kingdom minus expenses permitted under this law
Sources – Expenses
(c) The tax base of a non resident who performs an activity within the Kingdom through a permanent
establishment is his taxable income arising from or related to the activity of such establishment minus
expenses permitted under this law
Income – Expenses
(d) the tax base of each natural person is determined separately
(e) the tax base of a capital company is determined separately of its shareholders or partners
Article 7: Tax Rates
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(a) the tax rate of the tax base is 20 percent (20%) for each of the following:
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A resident capital company
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A non Saudi resident natural person who conducts business
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A non resident person who conducts business in the Kingdom through a permanent
establishment
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(b) the tax rate of the tax base for a taxpayer engaged only in natural gas investment activities is 30
percent
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(c) the tax rate of the tax base for a taxpayer engaged in the production of oil and hydrocarbon
materials is 85 percent
Chapter 2 – Taxable Activity and Tax-Exempt Incomes; Deductions and Losses
Article 8: Income subject to Tax
Taxable income is the gross income including all revenues, profits, and gains of any type and of any form
of payment resulted from carrying out an activity minus exempted income
Article 9: Gains and losses on disposal of assets.
(a) The gain or loss from the disposal of an asset is the difference between the compensation received
and its cost base
(b) No gain or loss on disposal of a depreciable asset is taken into account other than what is stated in
Article 17 of this Law.
(c) In determining taxable income, a natural person may not take into account gain or loss on disposal of
an asset that is not for use in the activity
(d) The cost base of an asset purchased, produced, manufactured, or constructed by the taxpayer is the
amount paid or incurred by the taxpayer in cash or in kind in the process of acquiring the asset.
(e) Where a taxpayer disposes of part of an asset, the cost base is apportioned between the part
retained and the part disposed of in accordance with their market value at the time of purchase
(f) Expenses incurred to alter or improve a non-depreciable asset are added to the cost base of the
asset.
(g) The compensation value for disposal of an asset against assets in kind is based on the
market value of those assets in kind, including exemption from debt on the asset
(h) Where a taxpayer disposes of an asset by gift or inheritance, the disposer is treated as
having received compensation equal to the market value at the time of disposal (unless
paragraph (i) applies.
(i) If an asset disposed of is encumbered by debt exceeding its market value, the taxpayer
disposing of the asset is treated as having received compensation equal to the value of the debt
(j) In determining tax base, no gain or loss is taken into account on an involuntary disposal of an
asset, to the extent that the compensation value is used to purchase of the same kind of asset
within one year of the disposal.
(k) The cost base of a replacement asset described in (j) is determined with reference to the
cost base of the replaced asset
(l) Where an asset owned by a taxpayer is converted to personal use or ceases to be used in the
generation of income, the taxpayer is deemed to have disposed of the asset for its market
value, with the recognition of the gain but not the loss.
Article 10: Exempt Income
The following types of income are exempt from income tax;
(a) Capital gains realized from the disposal of securities traded in the Stock Market in the
Kingdom in accordance with restrictions specified in the regulations
(b) Gains resulting from disposal of property other than assets used in the activity.
Article 11: Donations
In determining the tax base of each taxpayer, a deduction is allowed for donations paid during
the taxable year to public agencies or philanthropic societies licensed in the Kingdom which are
non profit organizations and are allowed to receive these donations.
Article 12: Expenses related to earning income
All regular and necessary expenses of earning taxable income, paid or accrued, incurred by the
taxpayer during the taxable year are deductible in determining the tax base, with the exception
of outlays of a capital nature and expenses according to Article 13 of this law.
Article 13: Non Deductible Expenses
No deduction is allowed for the following;
(a) Expenses not connected with the earning of taxable income
(b) Any amounts paid to a shareholder, partner or any of their relatives, which constitute
salaries, wages, awards or the like, or which do not satisfy the conditions for
transactions among independent parties
(c) Recreation expenses
(d) Expenses of a natural person for personal consumption
(e) Income tax paid in the Kingdom or another country
(f) Fines and financial penalties paid or payable to any party in the Kingdom
(g) Bribes or similar amounts considered a criminal offense.
Article 14: Bad Debts
(a) A taxpayer my deduct bad debts arising from the sales of goods or services that have
bee previously declared as taxable income of the taxpayer
(b) A bad debt may be deducted when stricken off the taxpayer’s books, when there is
suitable evidence proving the impossibility of collecting it as specified in the regulations
Article 15: Reserves and Allocations
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No reserves or allocations may be deducted except allocations of doubtful debts for banks
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The regulations shall determine the rules and restrictions specifying such allocations
Article 16: Research and Development Expenses
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Research and development expenses connected with the earning of taxable income may be
deducted
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Expenses for the purchase of land or equipment used for research and development may
not be deducted
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Such equipment shall be subject to depreciation under Article 17 of this Law
Article 17: Depreciation
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Depreciation is explained in Article 17 paragraphs (a) through (l)
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Terms and classifications are detailed in the Article to provide extensive guidance
Article 18: Expenses of Asset Repair and Improvement
(a) Expenses incurred by the taxpayer for the repair or improvement of depreciable assets in
each group may be deducted
(b) The amount of expenses deductible in accordance with paragraph (a) for each year shall not
exceed 4% of the balance of the value of the group at the end of that year
(c) The amount exceeding the limit in paragraph (b) will be added to the balance of the value of
the group
Article 19: Expenses for Geological Surveying and Preliminary Work for the Extraction of Natural
Resources
(a) Expenses of this Article are deducted in the form of amortization at the depreciation
rates determined in paragraph (b) of Article 17
(b) This Article also applies to expenses of intangible assets incurred by the taxpayer
Chapter 3 – Employee Expenses and Deferred Compensation; Accounting Periods and
Methods
Article 20: Contributions to an authorized retirement fund
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Contributions to an Authorized Retirement Fund
(a) An Employer’s contributions to an authorized retirement fund established in accordance with
the laws of the Kingdom may be deducted in favor of the employee
(b) the deduction allowed in paragraph (a) of this article shall not exceed 25% of each
employee’s income, prior to calculating the employer’s contribution
(c) The employee’s contributions to an authorized retirement fund may not be deducted
Article 21: Carrying forward losses
(a) a net operating loss may be carried forward to the taxable year following the year in which
the loss is incurred. The carried forward loss shall be deducted from the tax base of the
following taxable years until the cumulative loss is fully offset. The regulations shall specify the
maximum limits allowed to be annually deducted.
(b) a net operating loss is equal to the excess of the deductions allowed under this Chapter
which are in excess of the taxable income for the taxable year
(c) to calculate the net operating loss for a natural person, the deductions and income for
activity only shall be taken into consideration
Article 22: Taxable Year
(a) The taxable year is the State’s fiscal year.
(b) a taxpayer may use a twelve month period other than the one specified in paragraph (a) of
this Article as a taxable year, in accordance with the restrictions specified in the regulations
(c) see Article 22 for further explanation of about a short year and a long year in accordance
with the regulations
(d) Groups of related companies as defined in Article 64 of this Law, shall use the same taxable
year.
Article 23: Method of Accounting
(a) A taxpayer’s method of accounting must clearly reflect the taxpayer’s income.
(b) The gross income and expenses of a resident company, and any other taxpayer who keeps or
is required by law to keep commercial books according to the accounting principles generally
accepted in the Kingdom, are determined according to such books after adjustments of the
accounts so as to conform to the rules of this Law
(c) For taxation purposes, a natural person may record his transactions on a cash or accrual
basis. However, if his gross income from business for a taxable year exceeds the amount
specified in the regulations, he must use the accrual method in all succeeding taxable years.
(d) A company which keeps or is required by Law to keep commercial books must record income
and expenses on an accrual basis. Otherwise, it may for taxation purposes, use either the cash
or accrual method.
(e) Except for a change from the cash basis to the accrual basis required in accordance with
paragraph (c) or (d) of this Article, a taxpayer may change its method of accounting upon
obtaining the Department’s consent.
(f) If a taxpayer changes his method of accounting, it must perform adjustments to items of
income and deduction, or to debt or any other items in the taxable year following the change, so
that no item is omitted, or included more than once.
Article 24: Cash-Basis Accounting
A taxpayer who uses the cash basis method in its books and records shall register the received income
when received or made available, and the paid expenses when paid
Article 25: Accrual-Basis Accounting
(a) A taxpayer who uses the accrual method shall record income and expenses when they are due
(b) An amount becomes payable to the taxpayer when the taxpayer is entitled to receive it, even if
payment is postponed or pain in installments
(c) An amount becomes payable by the taxpayer when all the facts determining liability have
occurred
Chapter 4 – A Guide to Accounting Zakah Part 1
Introduction
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Zakah is a duty that must be fulfilled by all “capable” Muslims for it constitutes one of the
five pillars of Islam.
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This premise is taken for granted by all Muslims; scholars as well as common people
The most important questions are:
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How should a Muslim pay Zakah?
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What is the right way to pay Zakah?
Books of Fiqh (Islamic Jurisprudence) provide directions and details for this task
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To calculate alms (Zakah) on money for individuals and companies, an accountant needs
a guide to help him in defining the items of assets, on which alms are due
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The accountant also needs to know how to assess the liabilities which should be
reduced from assets for alms in order to reach the alms category and calculate the alms
which are due to be paid
First Essay: Accountancy Rules and Equations for Alms on Money
1. The annual rule
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Alms are calculated according to the lunar year. Counting starts when the amount of
money attains the Nisab (the minimum amount on which alms should be paid)
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This includes all kinds of alms except alms on agriculture, fruits, mineral assets and Rikaz
(metals found in the earth)
2. The rule of the independence of each year
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Each alms year is an independent one, and alms on a given amount of money should not
be more than once in the same year.
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Duality should be avoided
3. The rule of actual or assumed growth
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Actual or assumed growth of an amount of money is a condition for any alms to be
given from this money.
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Therefore alms are not due on fixed assets or things for personal use. This is because
the condition of actual or assumed growth would not be met.
4. The rule of capacity for obligation
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Alms are due on money which is abounding (more than basic needs). No alms are due
for little amounts of money.
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The amount of money should reach the Nisab. This guarantees that only those who
have the capacity of paying will be obliged to pay.
5. The rule of calculating alms on the total and the net amounts
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For every kind of money or activity there is a rule for calculating alms which are due on it. Some
are calculated in relation to the total amount and others are calculated in relation to the net
amount.
6. The rule of grouping monies of the same kinds
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It is permissible to group cash money of wealth to cash money available from offers of
commerce and other gained cash money so that for all these monies there would be
one Nisab and one alms year.
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However, it is not permissible to group different kinds of money. For example, cattle,
cash available from commercial operations, and agriculture and fruits should not be
grouped in one lump sum and the alms paid on them.
7. The rule of evaluating according to the current value of the market
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Evaluating cash money of wealth and cash money from offers of commerce to define
the alms due should be according to the current value at the time of paying alms
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They should not be evaluated according to historic value, cost or market, whichever is
less
The equations of calculating alms on money
1. Receptacle of alms money = alms assets – liabilities which are due to be paid at that moment
2. Alms assets = assets which meet the conditions of obligatory alms
The conditions of obligatory alms are:
a. It should be full ownership
b. Growth (actual or assumed)
c. Completion of the year (except alms on agriculture, fruits, mineral wealth, or
minerals of the earth
d. No other kind of alms has been paid on the same assets within the same year
e. Assets should abound basic needs
f. It should not include a debt which is due at the time
g. It should reach the minimum obligatory amount (Nisab)
3. Short term liabilities = short term liabilities which are due payment and in which the
conditions of decision are filled
a. Liabilities should be related to the activity
b. Due payment during coming year
c. Legally permissible
4. The amount due for alms (Nisab)= 85 grams of pure gold evaluated according to current
price
5. The amount of alms due = the receptacle of alms money once it reached the Nisab X the
price of alms
6. The price of alms = varies according to the kinds of money and activity. The range is
2.5% to 20%.
Chapter 5 – A Guide to Accounting Zakah Part 2
Second Essay; Executive Measures for Calculating Alms for Individuals and Companies
Alms on money should be calculated according to the following steps:
1. Defining the date completing the year. Varies according to the circumstances of the
alms giver
2. Different monies owned by the alms giver should be assessed at the end of the year
according to the rules of alms
3. Assessment of liabilities (deductions) which ae due to be decided upon, from alms
money according to the rules of Zakah
4. Defining the receptacle of alms by the deduction of due liabilities from alms money.
According to the following equation:
The receptacle of alms = alms assets minus due liabilities
5. Defining and assessing the amount of Nisab according to the kind of money, the kind of
activity, and the kind of alms. Nisab differs according to the kind of alms (on what will
the alms money be spent).
6. A comparison should be made between the receptacle of alms defined in step 4 with
Nisab defined in step 5 so as to know whether alms are due or not. If the receptacle
reaches the Nisab then alms would be due.
7. Define the amount which should be taken from the receptacle of alms, which
accountants term as the percentage or price of alms. See Guide for specifics on types
and amounts of alms.
8. Calculate the amount of alms by multiplying the amount of the receptacle by the
amount of the price (percentage) of alms. The result should be the amount of due alms.
9. Defining who pays the due alms are as follows;
a. For individuals and personal establishments; the individual or owner should pay the
due alms.
b. For partnerships; the amount of due alms should be divided between the partners
according to the percentage of his share
c. For investment companies; the amount of due alms should be divided on the
number of shares.
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Each investor then pays alms according to his shares.
d. For partnerships of labor and capital;
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The labor pays alms according to his share of profits
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The financier pays alms on capital and the profit less the laborer’s share
10. Revenue from alms should be distributed according to its due activities and persons in
the light of the rules of Islamic Law.
Alms money should be spent on the following:
1. The poor
2. The needy
3. Those who work in administering alms
4. Those whose hearts have been recently reconciled to the Truth
5. To free slaves
6. Those who are in debt
7. In the Path of Allah
8. The wayfarers
In order to calculate alms on money, an accountant needs the following tools and methods:
1.
General balance (financial situation) made on the date of calculating alms
2. Final accounts for the ended year on which alms are to be calculated
3. Clarification concerning the balance and the final accounts
4. The price of gold at the time when paying alms is due in order to calculate the Nisab.
5. Different monies possessed by the alms giver should be grouped if of the same kind
6. Different contemporary fatwas concerning alms
7. The Guide for calculating alms
8. Other accountancy tools and methods which may be useful for calculating alms
Chapter 6 – A Guide to Accounting Zakah Part 3
Simplified Accountancy Forms
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These forms are meant to be used as a guide for accountants when assessing the receptacle
of alms and when advising the alms giver whether he is an owner of a personal
establishment or a partner with others in a private company or a shareholder in an
investment company
Accountancy form to assess and calculate alms on wealth in cash
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The receptacle of alms on cash wealth includes banknotes, coins, silver, gold money and
ingots of gold, current accounts in banks and investment accounts
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The Nisab for cash wealth is 85 grams of pure gold, or its equivalent in cash, or 595 grams of
pure silver
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The Islamic Commission for Research has recommended to use the Nisab in gold.
The assessment and calculation steps are as follows:
a. Define the time when alms are due, (Al-Hawl), which starts from the time when the
amount of money reaches Nisab
b. Define all items of cash wealth, on which alms must be paid (alms assets)
c. Assess all items of cash wealth according to market value at the time when alms is
due
d. Settle all due liabilities on the alms giver from his cash wealth so that to know the
receptacle of alms
e. Compare between the receptacle of alms and the Nisab, if the receptacle reaches
the Nisab, then alms is due to be paid.
f. Calculate the amount of alms by multiplying the receptacle by the price of alms,
which is 2.5%.
g. See form on page 29 of Guide
Accountancy form to assess and calculate alms on goods for trading and industrial activities
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What is meant by goods for trading is anything which is to be bought or sold with the
intention of trading to earn a profit
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No alms are due on goods obtained for personal use
The assessment and calculation steps are as follows:
a. Define the end of the alms year, which is the same date as the end of the financial
year for an establishment or company
b. Define and assess the elements of alms assets such as goods, etc.
c. Define and assess the elements of immediate current liabilities which are due for
payment from the alms assets
d. Define the receptacle of alms by deducting item (c) from item (b) and add any
earned money
e. Define the amount of the Nisab, and then compare with the receptacle of alms
f. Calculate the amount of alms. If the receptacle reaches the Nisab, then alms should
be paid as 2.5% if lunar year and 2.577% if solar year.
g. See form on page 32 in Guide
Accountancy form to assess and calculate alms on agriculture and fruits
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Agriculture is anything that comes out of the earth and is planted by seeds from which man,
animal, and bird feed
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Fruits is everything which trees carry which is to be eaten
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Alms on agriculture and fruits are due at the time of harvest or collecting
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If an area of land produces more than one crop within the year, its owner should pay alms
on each crop separately.
The following are the steps of assessing the alms on agriculture and fruits:
a. Measure the total production of the land either by production or by cash
b. Define the expenses on the production, if the opinion adopted is that which says
that expenses should be deduced as far as they do not exceed the third, which is
the opinion of the Sixth Fiqh Seminar of Barakah.
c. Define the receptacle of alms by deducing item (b) from item (a).
d. Define the amount of Nisab, which is the equivalent to 5 Awsaq, or the
equivalent to 50 Egyptian Kaylah, or 653 kg of wheat or the average food for
most people
e. Calculate the amount of alms:
a. In the case of watering by cost alms = receptacle of alms X 5%
b. In the case of watering without cost, alms = receptacle of alms X 10%
See form on page 35 of the Guide
Accountancy form to assess and calculate alms on cattle
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Cattle includes camels, cows, and sheep
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Alms are due only if they are bred for multiplication and not used as animals of burden
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Nisab for alms on cattle differs according to the kind of species
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For camels it is five, for sheep it is forty, whereas for cows it is thirty
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Refer to Fiqh books for more details
The following are the steps of assessing the alms on cattle:
a. Define the number of cattle deducing the working animals and the ones ready for trade
b. Compare the number with Nisab, If it is less than Nisab then no alms are due.
c. Define the category the number falls into, in order to define the amount of alms due
d. Define the alms due according to tables in Fiqh books
See form on page 37 in the Guide
Accountancy form to assess and calculate alms on mineral and marine wealth and minerals in
the earth
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Mineral and marine wealth include anything of value which is brought out from the earth
or the bottom of rivers, seas, or oceans
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Minerals in the earth (Rikaz) are treasures which are buried in the earth
The following are the steps for defining the receptacle of alms on mineral and marine wealth:
a. Define the net production from the earth or sea, on which alms must be paid
b. Compare the net production with the Nisab (85 grams of gold) in he case of minerals of
wealth. For Rikaz there is no Nisab.
c. Calculate the amount of alms, if the receptacle reaches the Nisab, on the basis of 2.5%
for minerals and 20% for Rikaz
See form on page 39 of the Guide
Accountancy form to assess and calculate alms on revenue of investment assets
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Investment assets are any assets which remain fully owned whilst revenue from investing
them are re-occurring, such as real estate, cars, and others
No alms are due on the assets, however alms are due on the revenues once they reach
Nisab after deducing actually paid expenses and debts
Receptacle of alms on investment assets is calculated according to the following steps:
a. Define the total annual revenue at the end of the year
b. Define all expenses of getting the revenue
c. Deduce the expenses from the total revenue to get net revenue
d. Deduce currently due debts which the alms giver must pay
e. The net of all of the above should be added to any cash and trade goods owned by the
alms giver in which no alms were paid at the end of the year to ascertain the receptacle
of alms
f. Compare the receptacle (e) with the Nisab which is the equivalent to 85 grams of gold, if
the receptacle reaches the Nisab, then alms should be calculated on the basis of 2.5%,
which is the chosen opinion of the present guide.
See form on page 42 of the Guide.
Accountancy form to assess and calculate alms on revenue from work
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This category includes wages, salaries, income from freelance work and won money
Alms must be paid on what remains of this money at the end of the year by adding it to
other monies owned by the alms giver when calculating the Nisab and the alms year
The steps to define the receptacle of alms and calculate what is due at the end of the year are:
a. Define what remains from the revenue at the end of the year after deducing what is
paid from cost of basic need and after paying outstanding debts
b. Compare step (a) to Nisab (85 grams of gold) to know whether alms are due or not
c. Calculate the amount of alms if the receptacle reaches the Nisab on the basis of 2.5%
See form on page 44 of the Guide
See page 45 of the guide to determine alms on freelance work
See page 46 for form for freelance work
ACCT422 – Tax& Zakat Accounting
Chapter 2 – Determination of Tax
Formula for Individual Income Tax
Gross income – Exclusions = Gross Income (after exclusions)
Gross Income (after exclusions) – Deductions for AGI = Adjusted Gross Income (AGI)
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Tax rate schedules, std. deduction, personal exemptions, & other amounts are adjusted for inflation.
Actual amount paid
مبلغ معياري بموجب القانون
األكبر من االثنين
Adjusted Gross Income (AGI) – Deductions from AGI→ 1- Greater of
itemized deductions OR standard ded.
2- Personal and dependency exemptions
= Taxable Income
Taxable Income X Tax rate or rates = Gross tax
Gross tax – Credits and prepayments = Net tax payable OR refund due
Deductions from Adjusted Gross Income
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Itemized deductions
Standard deduction
Personal exemptions
Dependency exemptions
Child credit
Making work pay credit and social security tax reduction
Bashaier
Itemized Deductions
See Table 6 for partial list
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o
o
o
o
o
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Medical expenses
Taxes
Investment and residential interest
Charitable contributions
Personal casualty and theft losses
Miscellaneous deductions
Only claim itemized deductions if total greater than std. deduction
Some items limited by varying percentages of adjusted gross inc.
o Medical expenses
o Casualty losses
o Miscellaneous itemized deductions
Standard Deduction
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Varies based on:
o Filing status, age, and vision
o $6,100 – $12,200 in 2013
▪ Increase over 2012 to adjust for inflation
Increase std. ded. if elderly &/or blind
Used when std. ded. > itemized ded.
Limited std. ded. in certain situations
Personal Exemptions
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Generally, each taxpayer allowed one
o Unless claimed as dependent on another return
o $3,900 in 2012
Additional allowed for spouse on joint return
Bashaier
Dependency Exemptions
Requirements for All Dependents
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Have a qualifying identification number
Meet a citizenship test
Meet a separate return test
Not themselves claim another person as a dependent
Additional Requirements for Qualifying Children
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Relationship test
Age test
• < 19 or full-time student < 24
Abode test
• Live w/taxpayer > ½ of year
Support Test
• Dependent provides < ½ own support
Additional Requirements for Other Relatives
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Relationship test
• Related to or live w/taxpayer whole yr
Gross income test
• Dependent’s gross inc. < exemption amt.
Support test
• Taxpayer provides > ½ support
Determining the Amount of Tax
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Filing status
Joint return
Surviving spouse
Head of household
Single taxpayer
Married filing a separate return
Abandoned spouse
Dependents with unearned income
Bashaier
Filing Status
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Married filing jointly
• Marital status on last day of tax year
• Common law marriages recognized
• Spouses must be U.S. citizens or residents
• Federal Defense of Marriage Act of 1996 defines marriage as between a man and a woman
▪ Same-sex couples cannot file a joint federal return, but may file joint state return
in some states
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Surviving spouse
• Files as married filing jointly
Head of household
• Unmarried and maintains home in which dependent lives > ½ yr
•
•
•
•
Married filing separately
Single – taxpayers not in other categories
Relative tax liability by filing status from lowest to highest
• Married filing jointly
• Surviving spouse
• Head of household
▪ Includes abandoned spouse
• Single
• Married filing separately
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Chapter 3 – Gross Income: Inclusions
Concepts of Income
•
•
•
Economic concepts of income
Accounting concepts
Tax concept of income
Economic Concepts of Income
•
•
Wealth that flows to individuals
Changes in value in individuals’ wealth
o Unrealized gains
o Gifts & inheritances considered income
Accounting Concepts of Income
•
•
•
Values are measured by a transaction approach
Income realized as result of completed transactions
Use historical cost
Tax Concept of Income
•
•
•
•
Conditions to make income taxable
Administrative convenience
Wherewithal to pay
Gross income defined
Conditions to Make Income Taxable
▪
▪
▪
Economic benefit to taxpayer
Income must be realized
• Earnings process complete
Income must be recognized
Administrative Convenience
▪
▪
Economic concept is considered too subjective
Objectivity achieved at price of equity
Wherewithal to Pay
▪
A tax should be collected when the taxpayer can most easily pay
Gross Income Defined
▪
Section 61(a) defines gross income
• “all income from whatever source derived,” including (but not limited to)
the following items:
• Compensation, income derived from business, gains from dealings in
property, interest, rents, royalties, dividends, alimony, annuities, life
insurance, pensions
Bashaier
▪
▪
Form of receipt
• Gross income not limited to cash
• §1.61-1a, income may be “realized in any form, whether in money,
property, and services”
Indirect economic benefit
• Items indirectly benefiting taxpayers excluded from gross income
Allocating Income between Married People
▪
▪
Common law property system
• Used in 42 states
• Income taxed to person who earns it or who owns the income-producing
property
o Joint income comes from jointly owned property
Community property states
• All income deemed to be earned equally by spouses except income from
separate property
• Separate property of each spouse
o Property owned prior to marriage
o May be community income or separate income, depending on state
of residence
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When Is Income Taxable?
•
•
•
•
Cash method
Accrual method
Hybrid method
See Topic Review 1
Cash Method
▪
▪
▪
Cash receipts and disbursements
• Used by most individuals, and most non-corp. bus. with no inventory
Constructive receipt
• Report inc. in year actually received
o Check received after banking hours
o Bond interest coupons that have matured but not redeemed
No constructive receipt if
• It is subject to substantial limitations
• Payor does not have funds necessary to make payment
• Amount is unavailable to taxpayer
Accrual Method
▪
▪
Report income in year income earned
• Right to income
• Amount can be determined with reasonable accuracy
Prepaid income
• Generally taxable when received
• Exceptions in Rev. Proc. 2004-34
Hybrid Method
▪
▪
Accrual method for purchases and sales
Cash method in computing all other income and expenses
Bashaier
Items of Gross Income
•
•
•
•
•
•
•
•
•
•
•
•
Compensation
Business income
Gains from dealings in property
Interest
o Series EE bond interest exception
Rents and royalties
Dividends
Alimony and separate maint. pmts.
Pensions and annuities
Income from life insurance and endowment contracts
Inc. from discharge of indebtedness
Income passed through to taxpayer
Other items of gross income
Dividends
•
•
•
•
•
•
•
Included in shareholder gross inc.
Results in double taxation
o Earnings taxed at corporate level
o Earnings taxed at shareholder level when distributed as a dividend
o C corps allowed a 70, 80, or 100% div. rec. deduction based on ownership %
▪ Relief from multiple levels of taxation
Individuals taxed up to 20% on dividends
o Reduces effects of double taxation
o Must hold stock for at least 60 days
Distributions to extent they are out of corporate E&P
Stock dividends
o Not taxable
o Basis in stock allocated to new shares
Capital gain dividends
o Taxed at long-term capital gain rates
Constructive dividends
o Taxed as regular dividends
Bashaier
Alimony and Separate Maintenance Payments
•
•
•
Only receipt of alimony is taxable
o Alimony is deductible by one who pays
Child support not taxable
Property settlement not taxable
Pensions and Annuities
•
Income portion of annuity taxable
o Investment portion is excluded
Income Passed Through to Taxpayer
•
Income from flow-through entities taxed directly to owners
o Income from partnership
o Income from S corporation
o Income in respect of a decedent
o Income from an estate or trust
o Income from ETF, RIC, or REIT
Other Items of Gross Income
•
•
•
•
•
•
•
Prizes, awards, gambling winnings, and treasure finds – taxable
Illegal income – taxable
Unemployment compensation – taxable
Social security benefits – up to 85% taxable
Insurance proceeds & court awards
o Special rules apply
Recovery of previously deducted amounts – taxable
Revenue received that is disputed must still be reported as income
o Previously reported income that is subsequently refunded is deductible
Bashaier
Chapter 4 – Gross Income: Exclusions
Items that Are Not Income
•
•
•
•
Unrealized income
Self-help income
Rental value of personal-use property
Selling price of property
Unrealized Income
▪
Example:
• Land valued at $20,000 beginning of year appreciates to $45,000 at end of
year
o The $25,000 increase in value is unrealized income and not taxable
Self-Help Income
▪
The amount saved is not subject to tax
• Cleaning your own carpet
• Repairing your car
Selling Price of Property
▪
Only gain on sale of property is taxable
o Selling price – Basis in property = Gain on sale of property
Major Statutory Exclusions
•
•
•
•
•
•
•
•
•
•
•
Gifts and inheritances
Life insurance proceeds
Awards for meritorious achievement
Scholarships and fellowships
Distributions from qualified tuition programs
Payments for injury and sickness
Employee fringe benefits
Foreign-earned income exclusion
Income from the discharge of a debt
Exclusion for gain from small business stock
Other exclusions
Bashaier
Life Insurance Proceeds
•
•
•
Paid by reason of death
o Generally non-taxable
Policy surrendered not for death
o Excess of proceeds over the premiums paid taxable to recipient
Dividends on life insurance and endowment policies non-taxable
o Considered return of premiums paid
Awards for Meritorious Achievement
•
Awards for religious, charitable, scientific, etc. are not taxable if ALL criteria are met:
o Did not enter contest
o Is not required to perform substantial future services
o Designates a qualified charitable organization to receive the payment
Scholarships and Fellowships
•
Scholarships excluded for degree candidates used for qualified tuition and related expenses
o Required for courses of instruction at an educational institution
▪ Tuition, fees, books, supplies, equipment
o Not room and board
Distributions from Qualified Tuition Programs: §529 Plans
•
•
No tax on earnings while in §529 plan
Exclusion for distributed earnings if used by beneficiary for qualified tuition and related expenses
o Tuition, fees, books, supplies, equipment, AND
o Room and board if ≥ half-time student
Payments for Injury and Sickness
•
•
Injury includes physical and mental
o Medical expense pmts. for emotional distress excluded if expenses attributable to a physical
injury
Disability income policy is non-taxable if purchased by taxpayer
o Taxable if purchased by employer
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Foreign-Earned Income Exclusion
Eligible Taxpayers
•
U.S. citizens subject to U.S. income tax on worldwide income
o Subject to double taxation if foreign income taxed by foreign country
o Foreign tax credit (FTC) mitigates double taxation
Exclusion Amount
•
Foreign-earned income exclusion alternative to FTC
o May exclude up to $97,600 of foreign earned income
o Add’l exclusion for foreign housing costs
▪ Foreign housing costs in excess of $15,616
▪ Max housing exclusion is $13,664
Residency Tests
•
To qualify for foreign-earned income exclusion
o Must be bonafide resident of foreign country(ies) for entire taxable year,
OR
o Physical presence in foreign country for 330 days during a 12-month period
Income from the Discharge of a Debt
•
Generally, taxpayer may have to include amount of debt forgiveness in gross income
o Exceptions: nontaxable situations
▪ Discharge occurs in bankruptcy
▪ Discharge occurs when taxpayer is insolvent
Other Exclusions
•
•
•
•
•
•
•
•
•
•
•
Gain from sale of personal residence
Annuities paid to survivors of public safety officers
Certain military-related payments
Housing allowance for ministers
Campus housing
Foster care payments
Rural letter carrier’s allowance
Roth IRA distributions
Education IRA distributions
Personal foreign currency gains
See Table 2
Bashaier
Chapter 6 – Deductions and Losses
Classifying Deductions
for Adjusted Gross Income
•
•
•
Taxpayer benefits from deduction even if she claims the std. deduction
Reducing AGI: +/- benefits for t/p
▪ + Many deductions and credits phased out above certain AGI thresholds
▪ + Reduces AGI floors for certain categories of itemized deductions
▪ -Reduces certain deduction ceilings
Most common deductions for AGI
▪ Trade or business expenses
▪ IRAs and qualified pension contributions
▪ Alimony
▪ Losses on sale of bus/invest property
▪ Moving expenses
▪ Int. paid on qualified education loans
▪ ½ of self-employment tax
▪ Health insurance paid by self-employeds
from Adjusted Gross Income
•
Itemized deduction only will have tax benefit if total deductions exceed the taxpayer’s
standard deduction
▪ Deduct the higher of the standard deduction or sum of itemized deductions
Criteria for Deducting Bus. & Investment Expenses
•
•
•
•
•
Business or investment requirement
Ordinary expense
Necessary expense
Reasonable expense
Expenses and losses must be incurred directly by the taxpayer
Bashaier
Business or Investment Activity
•
•
•
•
•
Activity engaged in for profit
o Use facts and circumstances test
Trade or business (ToB) vs. investment classification
o ToB losses are ordinary losses
• ToB expenses are for AGI
o Investment losses are capital
• Invest. exp are from AGI
• Subject to 2% of AGI floor
Losses and expenses related to rents and royalties are for AGI deductions
Legal and accounting fees
• For AGI deduction for ToB if incurred in ordinary course of business
▪ Fees related to taxes also for AGI for ToB
Nonbusiness fees related to taxes from AGI deduction subject to 2% of AGI floor
Ordinary Expense
•
Ordinary expense requirements
• Reasonable in amount
• Bear reasonable proximate relationship to income-producing activity or property
• Must be customary or usual course of a particular industry or business community
Necessary Expense
•
An expense is considered necessary if it is “appropriate and helpful” in the taxpayer’s business
Reasonable Expense
•
Problems often occur with salaries for shareholder-employees of closely held businesses
Expenses and Losses Must Be Incurred Directly by the Taxpayer
•
Generally, a taxpayer cannot take a deduction for a loss or expense of another person
Bashaier
When an Expense Is Deductible .. Cash Method
•
Generally deductible when actually paid
•
Prepaid expenses
•
•
No current deduction if expenditure creates an asset with a life substantially beyond end of
tax year
▪ Exception for prepaid rent if prepmt ≤ 1 year and lease requires the prepmt
Prepaid interest
•
•
Amortize over period of loan to which interest charge is allocated
Points deductible over life of loan
▪
Points paid in connection w/purchase or improvement of a principal residence are
currently deductible
When an Expense Is Deductible .. Accrual Method
•
Allowed to deduct exp. in period in which exp. accrue under all-events test & economic
performance test
o All-events test (AET) met
▪ Amount of liability is established
▪ Amount of liability is determined with reasonable accuracy
o
Economic performance test (EPT) is met when EP deemed to occur
▪
Exception for recurring liabilities
•
•
•
•
All-events test met
EPT occurs w/in 8½ mo (or a reasonable period) after close of tax year
Exp. consistently treated as incurred in tax yr.
Item not material, or better matching w/AET
Bashaier
Chapter 7 – Itemized Deductions
Medical Expenses
•
•
•
Qualified individuals
Qualified medical expenses
Amount and timing of deduction
Qualified Individuals
•
•
Medical exp. paid for taxpayer, taxpayer’s spouse, or dependent
• Certain dependency test failures do not disqualify dependent
▪ Failing to meet gross income limit
▪ Failing joint return test
Noncustodial parent may claim deduction for dependent
Qualified Medical Expenses
•
•
•
•
•
•
Diagnosis, cure, mitigation, treatment, or prevention of disease
Transportation
• $0.24/mile std. mileage rate
• If overnight, includes
▪ Meals (50%) & lodging (≤ $50)
Cost of living in institutions
Capital expenditures
• Excess of cost over amount by which value of home increases
Medical insurance premiums
• Includes qualified L-T care premiums
No cosmetic surgery
• Unless treats illness or promotes proper body function
Amount and Timing of Deduction
•
•
•
Deductible in year paid for qualified medical exp. exceeding 10% of AGI
• 7.5% for taxpayers > 65 until 2016
Medical insurance reimbursements
• Only unreimbursed portion deductible
Self-employeds may deduct health insurance as a for AGI deduction
Bashaier
Taxes
•
•
•
•
•
•
•
•
•
Definition of a tax
Deductible taxes
State and local income taxes
State and local sales taxes
Nondeductible taxes
Personal property taxes
Real estate taxes
Self-employment tax
Nondeductible taxes
Definition of a Tax
•
Mandatory assessment levied under authority of a political entity for purpose of raising revenue
used for public or governmental purposes
Deductible Taxes
•
•
•
•
•
State, local, & foreign real prop. taxes
Some state and local personal prop. taxes
Foreign, state &, local income, war profits, and excess profit taxes
State & local sales tax election
Environmental tax
Nondeductible Taxes
•
•
Taxes imposed by the Federal gov’t generally not deductible
Exceptions
• Employer’s share of Social Security tax
▪ Deductible by employer as bus. expense
• Federal import tariffs & excise taxes
▪ Deductible if for business or production of income
Charitable Contributions
•
•
•
•
Qualifying organizations
Type of property contributed
Deduction limitations
Application of carryovers
Qualifying Organizations
•
•
•
•
U.S., D.C., state, or U.S. possession
A post or organization of war vets
Domestic fraternal society, or order, or association
Public Charities
• Churches, educational Institutions, hospitals, medical schools
Bashaier
Type of Property Contributed
•
•
•
Contribution of long-term capital gain property
• Generally FMV
▪ Use adjusted basis if
• Contributed to private nonoperating foundation
• Unrelated use by charitable organization
• Certain intangibles
Contribution of ordinary inc. prop.
• Value generally adjusted basis
• Exception for C corp donation of certain inventory
▪ FMV – (50% x [ordinary inc. if sold])
Contribution of services
• Only out-of-pocket and transportation expenses deductible
Deduction Limitations
•
•
•
•
•
50% of AGI limitation
• Applies to public charities
30% of AGI limitation
• Contributions of capital gain property
20% of AGI limitation
• Capital gain property contributed to private nonoperating foundations
Order of deductions
•
50% property
•
30% property
•
20% property
Combined contributions cannot exceed 50% of AGI
Casualty and Theft Losses
•
•
Individuals can deduct casualty or theft loss on personal-use property as an itemized deduction
See Chapter 8
Miscellaneous Itemized Deductions
•
•
•
•
Certain employee expenses
Expenses to produce investment income
Cost of tax advice
See Chapter 9
Bashaier
Certain Employee Expenses
•
Unreimbursed employee business expenses
• Include travel, transportation, dues to professional organizations, cost of job hunting
• Generally misc. itemized deductions subject to a 2% of AGI floor
Expenses to Produce Investment Income
•
•
Expenses to produce investment income other than rents or royalties
Miscellaneous itemized deductions subject to 2% of AGI floor
• Investment interest NOT subject to the 2% of AGI floor
Cost of Tax Advice
•
•
Includes
• Tax return preparation fees
• Appraisal fees in determining amount of casualty loss
• Accountant fees for representation in a tax audit
Miscellaneous itemized deduction subject to 2% of AGI floor
Bashaier
Chapter 8 – Losses and Bad Debts
Transactions that May Result in Losses
•
•
•
•
•
Sale or exchange of property
Expropriated, seized, confiscated, or condemned property
• Treat as sale or exchange
Abandoned property
Worthless securities
Demolition of property
• Add to basis of land
Sale or Exchange of Property
•
•
Amount realized includes liability transferred to buyer
• Qualified residence exception
▪ No gain on transfer AND no discharge of indebtedness income
Selling costs
• Deducted in year incurred for inv.
• Reduction of amt realized for noninv.
Abandoned Property
•
•
Ordinary loss if business or investment property
Nondeductible if personal property
Worthless Securities
•
•
Securities must be completely worthless
Capital loss on last day of tax year
Classifying the Losses on Taxpayer’s Tax Return
•
•
Ordinary vs. capital loss
Disallowance possibilities
Bashaier
Ordinary vs. Capital Loss
•
•
•
Based on of type of property and type of transaction involved
§1231 property
• Net §1231 loss is an ordinary loss
• Includes real or depreciable property used in a trade or business and held for more than one
year
§1244 stock
• Loss on sale of §1244 stock ordinary
▪ Limited to $50K ($100K MFJ)
▪ Excess loss is a capital loss
• §1244 stock qualifications
▪ ≤ 50% of gross receipts from passive sources during prior 5 tax years, AND
▪ Contributions to capital and paid-in surplus ≤ $1M at time of issue
Casualty and Theft Losses
•
•
•
•
•
•
•
Casualty defined
Theft defined
Deductible amount of casualty loss
Limits on personal-use property
Netting casualty gains and losses on personal-use property
Casualty gains and losses attributable to business and investment property
Timing of casualty loss deduction
Casualty Defined
•
•
A casualty loss results from an identifiable event that was sudden, unexpected, or unusual
Qualifying casualties include fire, flood, hurricane, tornado, and hail
Theft Defined
•
•
Generally, criminal intent and violation of state law required to meet definition of theft
Includes larceny, embezzlement, robbery, blackmail, extortion, and ransom
Deductible Amount of Casualty Loss
•
Generally decline in FMV due to casualty
• For partial destruction loss is lesser of decline in FMV or adjusted basis
• Total destruction of business or investment property amount of loss is adjusted basis
Limitations on Personal-Use Property
•
Two limitations
• Losses sustained in each separate casualty reduced by $100, AND
• Sum of all net casualty losses reduced by 10 % of taxpayer’s AGI
Bashaier
Netting Casualty Gains and Losses on Personal-Use Property
•
•
Losses reduced by insurance reimbursement
Casualty losses must be netted against casualty gains prior to applying 10% of AGI limitation
• Net casualty loss subject to 10% limitation
Casualty Gains & Losses Attributable to Business & Investment Property
•
•
For AGI deduction
• Investment property must be used to generate rents or royalties
• Losses on other investment property are miscellaneous itemized deductions NOT subject to
2% of AGI floor
If property held 12 months
Overnight requirement
•
•
Must be reasonable for taxpayer to be away overnight
Short rest stops on long day-trip not considered overnight
Business vs. Pleasure
•
•
Travel to and from destination
o If trip primarily personal, no deduction
o If trip primarily business, all travel to and from destination deductible
Other travel-related expenses
o Allocated to business and personal activities
Transportation Expenses
•
•
•
Definition and classification
Treatment of automobile expenses
Reimbursement of automobile expenses
o Excess expenses over reimbursement deductible as 2% misc itemized deductions
Definition and Classification
•
•
•
•
Commuting costs generally nondeductible personal expenses
Commuting costs between multiple jobs for same taxpayer deductible
Transportation costs from employee’s regular work site to temporary one deductible
Commuting costs between home and temporary work site deductible if taxpayer has regular place
of business
Treatment of Automobile Expenses
•
•
Standard mileage rate $0.565/mile
o Not available if use ≥ 2 vehicles
o Does not include parking and tolls
Actual expenses
o Includes gas, oil, maintenance and repairs, insurance, and depreciation
o Based on ratio [Bus. miles]/ [Total miles]
Bashaier
Office in Home Expenses
General Requirements
•
Office used on exclusive and regular basis and ONE of following
o Office used as principal place of business for any ToB
▪ Includes doing administrative work if no other fixed location available
o Place for meeting clients in normal course of business
o Located in separate structure
•
An employee must also prove that the home office is for the convenience of the employer
o
Not just appropriate or helpful for the employee
Deduction and Limitations
•
Categories of expenses
o Expenses directly related to office
o Expenses indirectly related to office
▪ Expenses related to whole home
▪ Prorate based on square footage or other method
o Total expenses cannot create loss
•
Order of expense deductions
1. Expenses not related to home office
2. Expenses directly related to home office
3. Pro-rata portion of indirect expenses
▪
E.g., mortgage, interest, utilities
•
Disallowed expenses carried forward to future year
•
Optional safe harbor to determine amount of deductible home office expenses per Rev.
Proc. 2013-13
o
$5 multiplied by
[sq. ft. of space for qualified use]
▪
Limited to 300 sq. ft.
•
$1,500 maximum deduction
Bashaier
Chapter 11 – Accounting Periods and Methods
Accounting Periods
•
•
•
•
•
Fiscal year is any 12-month period other than calendar year
Partnerships, S corps, and PSCs
o Generally must have same tax year as majority owners (> 50% ownership)
Required payments and fiscal years
Changes in the accounting period
Returns for periods of < 12 months
Required Payments and Fiscal Years
•
•
C corporations, other than PSCs, can choose any fiscal year
Partnerships, S corps, and PSCs can choose a fiscal year if deferral is 3 months or less (§444 election)
Changes in the Accounting Period
•
•
Generally need IRS approval to change accounting period
Must establish substantial business purpose to change accounting period
Returns for Periods of Less than 12 Months
•
•
Taxpayer’s first or final return
o No annualization of income required
Change from one accounting period to another
o Annualization required
Overall Accounting Methods
•
•
•
•
Overall accounting method for one trade or business not needed to be used in a second trade or
business
Cash receipts and disbursements method
Accrual method
Hybrid method
Cash Receipts and Disbursements Method
•
•
•
•
•
Report income for the tax year in which payments are received
Generally deduct exp. in year paid
o Prepaid exp. capitalized and amortized if benefits extend beyond tax year
Must capitalize fixed assets and recover through depr. or amort.
Most individuals and many service businesses use the cash method
Cannot use cash method in a business where inventory is material income-producing factor
o Small business exception – see hybrid method
Bashaier
Accrual Method
•
•
Report income under all-events test and economic performance test
o All events test
▪ Taxpayer’s right to receive inc. & amount determined w/reasonable accuracy
o Economic performance test
▪ Property or services actually rendered by other party
Deduction is met when liability established and amount of expense can be determined with
reasonable accuracy
Hybrid Method
•
Use accrual method for sales and purchases, but may use cash method for other income and
expenses
o Small business exception
▪ Businesses with inventory whose annual gross receipts for 3 prior years ≤ $1M may
use cash method for sales and accrual method for cost of goods sold
Inventories
•
•
Uniform capitalization rules (UNICAP)
o Required for taxpayers whose average gross receipts for 3 prior years >$10M
o Must capitalize some period costs
If using LIFO for tax
o Must also use LIFO for financial acctg.
Change in Accounting Methods
•
•
•
•
Accounting period chosen by using for first year in which it is applicable
o IRS approval required to change methods
o May change to LIFO method without IRS approval
Amount of change
o Due to timing of income and deduction recognition due to changes between cash and
accrual methods
Reporting the amount of the change
o The amount
o Change voluntary or involuntary
o Any specific statutory mandates
Must obtain IRS consent
Bashaier
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