Enrolled Agent Exam Prep Course, Part 1, Video 2/7, 2025

Welcome to video two of part one of the EA tax training free EA exam prep course for 2025. Tom here, back with you to discuss income. Specifically, what we will cover in this video are types of income: wages and employee compensation, injury and illness income, interest, dividends, and other income.

We're not going to cover all types of income in this video because some specific types will be covered in later videos. So, the next video after this one is all about capital gains, so we'll discuss that in video three. Then, we will also discuss retirement plans and Social Security in a separate video. And finally, our last video in part one will cover specialized topics in returns, where among other things, we'll talk about foreign income and accounts.

Our free resources from IRS.gov. The first two you'll recognize from the first video: Publication 17 and Form 1040 and its instructions. And then for this video, the other one in bold is Publication 525, Taxable and Non-Taxable Income. I do recommend that you get that publication, read through it, and study it as part of your preparation for the exam. And then the other publications here also might be of interest to you if you want to know more about those specific topics.

As far as our flow of the tax return, we are up here in gross income at the top of that chart. So let's start talking about types of income. These are going to be some definitions so that when you hear these terms throughout this course or when you're reading through the publications and the forms, you understand what the IRS means when they talk about this type of income or that type of income.

So, the first most basic types of income we want to talk about are taxable income versus non-taxable income. So, taxable income must always be reported, even if you don't get a form. If you don't get a 1099 or you don't get a W-2 or a K-1 or any other type of form, you still have to report any taxable income that you received. And then, of course, we have non-taxable income, which usually does not have to be reported. There are some exceptions that we will talk about as we go through this course.

So, taxable versus non-taxable is obviously very important when we're trying to determine how much tax that the taxpayer is going to pay. So, how do we know if the income is taxable or not? Well, the default answer is yes, unless that income is specifically excluded by law, then it is considered to be taxable. And this comes from the Constitution of the United States. The 16th Amendment to the Constitution was passed in 1913, and what it says is, "The Congress shall have the power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States and without regard to any census or enumeration."

So, what had happened was in the 1800s, Congress had passed an income tax law, and it made its way through the courts. It was challenged, and eventually, the Supreme Court determined that the income tax was unconstitutional. So, what Congress did in response was they passed the 16th Amendment, and it includes, as it says, "income from whatever source derived." So that's very broad. That's a phrase you might want to remember. It could end up on the exam, and it includes illegally obtained income as well as legally obtained income.

You're probably familiar with the case of Al Capone, who was a famous gangster in Chicago back in the 1920s and 1930s during Prohibition time. And he was suspected of committing all kinds of crime, up to and including murder. And he did gun running, and of course, he was producing and selling illegal alcohol during Prohibition. But they couldn't prove any of those other crimes. But what they could prove was that he had income that he had not reported and paid taxes on. So, ultimately, he went to prison for not paying his income taxes. And this type of thing even happens today. You've got drug dealers and things where they can't pin that crime on them, but they can show that they had all this income that they didn't report, and those people can still go to prison for tax evasion, even if they can't prove their other crimes that they are committing.

Next, we want to talk about earned versus unearned income. And we did talk about this a little bit in the first video, but we will talk about it again. Earned income comes from working or performing services. So, it includes wages, salaries, tips, professional fees, and self-employment income. You'll remember when we were talking about your earned income and how much you needed in order to have to file a tax return, we also included the taxable portion of scholarships and grants in here. And that is true, but most of the time when we are talking about earned income, we're talking about those things that you usually think of as being earned, that you work for that money specifically.

And then unearned income is the opposite. So, it's not directly from current work or performance of services. So, it includes interest, dividends, capital gains, retirement income, life insurance proceeds. So, again, retirement income, Social Security income, you did work for those during your working time, but now you are receiving those after you have finished working. So, it is not considered earned income.

And one distinction we do want to keep in mind is that earned income usually is going to be subject to Social Security and Medicare taxes, while unearned income is not. You're going to see that theme coming up over and over again, both in parts one and parts two of this course. And so, the easy way to remember this is you may have had this experience. If you can remember the first time you got a job and you got your first paycheck, and there was less money in that paycheck than you expected. And so you looked at your pay stub and you realized that all this money had been withheld from your paycheck. First of all, there was income tax, likely that was withheld. But then you looked on there, and there was something called FICA and something called Medicare, or it said MCR, and you're confused, and you're like, "What is this?" Well, FICA stands for Federal Insurance Contributions Act. That's the other name for Social Security. And then MCR stands for Medicare. So, when you have earned income, such as from that first job or any job that you have, they are going to withhold Social Security and Medicare tax from that. So that's the way you can remember that earned income has those things withheld, whereas unearned income does not. You do not have to pay Social Security and Medicare taxes on unearned income.

Next, we'll talk about investment income, sometimes called portfolio income. So, this includes things like interest, dividends, capital gains, rents, and royalties. Now, these things are also unearned income, but this is just a little bit more specific. These are being called investment income, obviously, it's income that comes from money that you have invested. And if you want more information about that, you can check out Publication 550.

Our next distinction is active versus passive income. So, active income is generated by an activity engaged in for profit in which you materially participate. And material participation means you are involved in the operation of the activity on a regular, continuous, and substantial basis. And we'll talk more about that in part two of the course. But for now, just understand that active income is from actually working in a business, as opposed to passive income, which is generated by an activity engaged in for profit in which you do not materially participate, or by rental property. So, if you have rental property, even if you materially participate, it is still considered passive income. And we'll talk more about rental property in part two of the course as well.

So, you have probably heard of a business that has a silent partner. So, maybe you've got two partners in a business. One of them is the one with the know-how, and they are actually the one that's out there doing the business, they are working in the business and getting the job done. And then you've got the other partner in the background who's the quote-unquote silent partner, and they just invested money, but they don't actually work in the business. So, in that case, the partner who's actually doing the work, he or she, their income, the partnership is active income. Whereas for the silent partner, the income from that partnership would be considered passive income.

And the reason this is important is because if you have losses from passive activities, then you cannot deduct those losses against active income or against non-passive income. And for this purpose, portfolio income or investment income is not considered passive. So, in other words, if you've got a whole bunch of interest and capital gains and dividends, you cannot use passive losses to offset that investment income. You can only use passive losses to offset passive income. So, if you've got active income, or if you've got interest and other portfolio income, you cannot take passive losses against that income. So that's why you need to know the difference between active income and passive income.

Next, let's talk about cash versus accrual accounting. As individual taxpayers, we are all on the cash method of accounting. So, what that means is that income is recognized when it is received, and expenses are recognized when they are paid. So, for example, if you work at a job in the last couple weeks of December of 2024, but then your employer does not issue your paycheck for those last couple weeks until January of 2025, that is considered income to you in January of 2025. It is not considered 2024 income, even though you earned the income in 2024, because we are on the cash method of accounting, we do not recognize that income until it is actually received. Similarly, if you pay expenses or you have any deductions that were paid in 2025, even if they were incurred in 2024, you would not recognize those until 2025. So, let's say you had a mortgage payment that was due in December of 2024, but you were late and you didn't pay it until January. That interest expense, that you would have, the mortgage interest expense, would be a deduction in 2025 rather than in 2024, even though technically it was your 2024 mortgage payment, because you didn't make it until 2025, that's when it counts.

So, this is how, of course, individuals determine their income and deductions. And also, many small businesses are on this method, the cash method. The other way that we could do this is called the accrual method. So, in this case, income is recognized when it is earned rather than when it is actually received, and expenses are recognized when they are incurred rather than when they were actually paid. So, that paycheck that you didn't get until January, if you were on the accrual method, since you earned that money by working in December, you would have counted that income in December in 2024 instead of in 2025. But of course, since you're an individual, you don't do that, you're on the cash method. But that's how the accrual method would work. And similarly, that December mortgage payment, since it was the December payment, would have counted as mortgage interest in December of 2024 instead of when you paid it in December of 2025.

So, many businesses, like all the large Fortune 500 companies that you see, they all use the accrual method, and it is technically the correct method for business accounting purposes. So, if you take an accounting course in college or something, you are learning primarily the accrual method of accounting. And we will talk more about this in part two, but it is important for you to understand that as individual taxpayers, for part one, they are on the cash method of accounting.

Constructive receipt. So, sometimes people will hear about this cash versus this accrual method in accounting, and they'll get a bright idea and they'll say, "Okay, somebody paid me money. They wrote me a check in December of 2024 for some services that I performed. So, what I'm going to do is I'm going to wait, and I am not going to deposit that check until January. As a matter of fact, I'm just not even going to pick it up. I'm not even going to get that check from them until January." That way, I don't have to record the income this year, 2024. I can wait and pay tax on it next year in 2025. But you cannot do that. The IRS has already thought of this.

So, what constructive receipt says is, if you could have had the money, but you just chose not to take it, you still have to count it as income. So, you constructively receive income when it is credited to your account or set apart in any way that makes it available to you, and you do not need to have physical possession of it.

So, let's look at an example. Your employer prepares a paycheck for you on December 29th, 2024, but you don't pick it up and deposit it in the bank until January 2nd, 2025. Well, that is considered income received in 2024. Next example: Per a court order, your employer garnishes $100 from your paycheck to be handed over to the court. You constructively received that $100. Now, you might complain, "Hey, I never actually got the $100." But the IRS just considers that you actually did receive the $100, and then you just turned it over to the court. So, they just skipped the middleman by having your employer send that money directly to the court.

So, now let's talk about specific types of income. And we will start with wages and employee compensation. If you receive compensation for working, then you must report it. And again, it doesn't matter whether or not you received a W-2 or a 1099 or any other type of form. If you receive that compensation, then you must report it. Now, usually, if you've got a job, you will receive a W-2, which shows your wages and tips, the amount of income tax that was withheld, that Social Security and Medicare tax that was withheld, and there's other information that is typically on there as well. Even if you don't receive a W-2, of course, it is still taxable.

So, why would you not receive a W-2? Well, an example of this would be a household employee. So, some people will have in their private residence, they'll have someone come in who is an employee. They might be a nanny, they might be a housekeeper, they might be someone who is taking care of an elderly person, something like that. So, they can actually be an employee, and then they will get a W-2. However, the way the rules work is if they make less than $2,800 for the year, then they don't have to have a W-2. That household employer does not have to issue them a W-2. And we'll talk more about household employees in a later video. But for now, just let's say that that person's a nanny, they are an employee, but they only made $2,500 for the year. Well, that household employer does not have to issue them a W-2, but the nanny does still have to report that $2,500 as income on their return.

And then another reason you may not get a W-2 for work that you have done is because the business that is paying you considers you to be an independent contractor, in which case they may issue you a 1099 instead. So, let's talk about this distinction between being an employee for the W-2 and an independent contractor. So, this whole topic of "Are you an employee or are you an independent contractor?" is controversial, and again, we'll talk more about it in part two of the course. But for now, we want to understand at least the basics of it.

From an employer's standpoint, or from a business who's paying people to do work for them standpoint, they would generally rather have the people that they are paying be independent contractors rather than employees. Why? Well, because they can save on payroll taxes. So, remember when we talked about Social Security and Medicare taxes? So, as an employee, when you get a W-2, of course, they withhold those amounts from your paycheck. However, that's not the end of it, because not only do you have to pay in those amounts for Social Security and Medicare, but your employer has to match that. So, whatever amount you paid, your employer also has to pay in out of their own funds, the same amount. Then there can be other payroll taxes as well, such as unemployment taxes that the employer has to pay. So, you can see, if you got a whole lot of employees, all of these employment taxes or payroll taxes can really add up.

Whereas, if you are an independent contractor instead, then the business paying the money doesn't have to pay any of those taxes. Instead, the independent contractor is considered to be in business for themselves, and they file a Schedule C with their 1040, and they have to pay something called self-employment tax. And self-employment tax is in place of Social Security and Medicare tax. But since that person is in business for themselves, they have to pay twice as much as if they were an employee, because if they're in business for themselves, they are not only the employee, they are also technically the employer. So, they have to pay both the employee's portion of Social Security and Medicare, and the employer's portion of Social Security and Medicare. And that is called the self-employment tax.

So, this is why these businesses would rather call the people that work for them independent contractors. And if you read the news closely, you will see these cases come up, and usually the government is coming in and stepping in and suing a company and saying, "Hey, you need to be treating these people as employees rather than as independent contractors." And then you get these big court battles. So, for now, for part one of the exam, you can just make a simple distinction: if they receive a W-2, you consider them to be an employee. If they receive a 1099, then you consider them to be an independent contractor.

So, what kind of 1099 might they receive? Well, they should be receiving, most of the time, a 1099 NEC, which stands for Non-Employee Compensation. And this came back into use in 2020. So, it had been used back in the 1980s, and then it fell out of favor with the IRS, and they said, "Well, you should use a 1099 MISC instead." But in 2020, they brought back the 1099 NEC. So, any business that pays someone who's not an employee to do work for them, and they pay them more than $600 for the year, then they have to issue that person this 1099 NEC.

A 1099 MISC is used for various purposes. The most common one is for rent. So, a business is renting their office space, they would send the landlord a 1099 MISC if they pay them more than $600 in a year. Another kind of 1099 that an independent contractor may get is a 1099 K. So, this comes from credit card processors and online apps. So, if you have a business, even if you are an individual, it's a one-person business, and you accept credit cards, then you are going to process that credit card, and then the bank or the credit card processor is going to subtract a little bit of a fee from that, then they are going to send you the difference. And that credit card contractor then will at the end of the year send you a 1099 K to say how much money they sent you.

Similarly, if you or clients work for these gig economy type of companies, Uber and Lyft and DoorDash and Instacart, and so forth, if they meet the minimum income requirements, then those companies will send that person a 1099 K showing how much they paid. And it can also come from payment apps for business. So, if you've got PayPal or Venmo for business, then they will similarly send you a 1099 K at the end of the year.

Now, it used to be they didn't have to send one of these unless they paid you more than $20,000 in the year, and there also had to be a minimum number of actual transactions during the year before they had to send you a 1099 K. But that is now changing. So, the IRS went back and forth on this for a couple of years, but this is what they settled on. They are now transitioning over from that $20,000 number. Eventually, they're going to get back down to $600, like it is for the other 1099s. But for now, what you need to know for the 2025 EA exam is that for 2024, if any of these people paid more than $5,000 during the year, then they must issue a 1099 K. So, if you're accepting credit cards and you got more than $5,000 during the year, then you should expect a 1099 K. Or if you're doing Uber or DoorDash or one of those, and you got more than $5,000 during 2024, you should expect a 1099 K.

Now, you should not get both a 1099 K and a 1099 NEC for the same income. But sometimes it happens. Sometimes these businesses will make mistakes. So, for instance, they may make a payment, and they make it by credit card, and they issue you a 1099 NEC for that, which they should not do. They should not issue you a 1099 NEC for any amounts that they paid you with credit card, because you're going to get a 1099 K for that. But sometimes they make mistakes. So, you, as the tax preparer, want to just make sure that this income has not been doubled up and double counted.

Now, for any kind of 1099 that you get, sometimes they will make a mistake on the 1099. So, if you file your return based on a 1099 that you got, and later are issued a corrected form, corrected 1099, then you may need to go back and file an amended tax return in order to either increase or decrease your income due to that new 1099. And you file that amended return using something called Form 1040X, that we will talk about later.

Other types of employee compensation. So, any of these that you get, you will include in income in the year received. So, advance commissions. So, if you get paid commissions in anticipation of you, for instance, making sales in the future, that is income in the year it is received, even though you may not technically be earning those commissions until later. Remember, we're on the cash basis, so it is income in the year received. Similarly, back pay awards. So, this is income for work that you did in the past, and they're paying you now. It's included when you receive it. Any bonus or award that you get is included. There is an exception for certain length of service and safety awards, but most of the time, if you get a bonus or any type of award, it's included in your income.

Differential wage payments, for example, for military reservists. So, some companies, if they have employees who are in the military reserves, and those employees get called to duty, and now they're going and they're working for the military. Well, while they are working for the military, they are getting paid by the military, but often they're not getting paid as much as they would be getting paid if they were back at home doing their regular job. So, some employers will make up the difference. So, even though that person is off working for the military, they're not working for that company at the time, that company says, "Hey, we appreciate your service, and so we are going to go ahead and make you whole, and we are going to pay you the difference between what you're making in the military and what your normal salary is." So, if that person receives that money, then of course, that is considered income, just like any other salary that they would receive.

Severance pay. So, if someone's leaving a company and they get a big payout for severance pay, that's included in income. Accrued leave pay. So, again, maybe they're leaving the company, and they've got a bunch of PTO built up, and that gets paid out, that is income. And similarly, if they get sick pay, whether they're still working and they get it, or they leave the company and they get paid out for it, then that is included in income.

One thing that is not included in income generally is expense reimbursements. So, if you're, for instance, traveling on business, and you charge a hotel and some meals and other things to your personal credit card, then you submit the receipts to your employer, and they pay you back, that is not income.

Fringe benefits. So, the general rule, the default for fringe benefits is that they are included in income in the year received, unless they are excluded by law. But there is a whole laundry list of fringe benefits that are excluded by law. So, we're going to go through some of those here. The first ones on this slide all have to do with various types of health insurance. So, accident and health insurance premiums. So, if you work for a company, they provide health insurance, the amount that they pay for the health insurance premiums is not included in income. As a matter of fact, the amount that you pay, so if you have amounts that are withheld from your paycheck to pay for health insurance, those are not included in income either, meaning those amounts are deducted from your salary pre-tax. They are deducted before you have to pay tax. So, those amounts are not taxable, as well as the amounts that the employer pays are not taxable either. Similarly, long-term care and insurance premiums, if you're getting those from your employer, not included in income. Something called Archer MSA contributions. These Archer MSA accounts, you can't actually start a new one, they're not a thing anymore, but any accounts that already were in existence, if there were contributions that your employer made to those, not taxable income. Health flexible spending account salary reductions up to $3,200 per year and any employer reimbursements, not included in income. Health reimbursement plan payments, not included. And health savings account contributions are also not included in your income. There is this exception for 2% S Corp shareholders that we will talk about in part two.

Other fringe benefits that are excluded: adoption assistance. You can see Form 8839 for more information on that. De minimis benefits. You'll see this phrase de minimis often in the tax law. It just means small. So, for instance, if you get a discount in the employee cafeteria, or the company pays for your cab ride or your Uber ride home because you're working late one night, those types of things would not be included in your income. Other things might be if your employer lets you use their copy machine to make a small number of copies for personal use now and then, that type of thing, not included in your income. Non-cash holiday gifts of nominal value. So, this is the stereotypical turkey or ham that the employer might give to employees. Educational assistance up to $5,250 per year within certain guidelines. Qualifying student loan payments. So, some companies are actually helping to pay off employees' student loans. So, if they do that up to $5,250 per year, not included in income. Group term life insurance of up to $50,000, not included in income. For amounts over $50,000, it will be reported on the W-2, and the employer uses a formula that the IRS provides in order to determine how much to put on the W-2.

Other fringe benefits that are excluded: retirement planning services provided by a qualified retirement plan. So, maybe you've got a 401(k) plan at work, and as part of that, the company that is administering the 401(k) plan for your employer, they might provide some retirement planning. They may have someone come in to the workplace and say, "Hey, here's how you might want to invest your money," and that type of thing. Those types of services, not included in income. However, that does not extend to things like tax preparation, accounting, and legal or brokerage services. So, if your employer is providing those services to you, those would be included in income.

Qualified transportation benefit. You'll want to remember this for the exam. If you get transportation provided for you by your employer in a commuter vehicle, such as a van, between home and work, you can exclude up to $315 per month for that. Similarly, if you get a transit pass, like a subway pass, up to $315 per month can be excluded. And qualified parking, up to $315 per month can be excluded. You'll want to remember that $315 per month, and that it applies to these various types of transportation benefits.

Child and dependent care benefits. So, amounts that are received for dependent care can also be excluded within the guidelines. The amount excluded is the lesser of $5,000 or $2,500 if you're married filing separately, but $5,000 or the actual expenses that you had during the year. Those are expenses that were incurred during 2024, regardless of when they were paid. So, this is an exception to the cash method of accounting. So, if they were incurred in 2024, taxpayers earned income, or the spouse's earned income. So, you take the lesser of all of those things. That is the amount that can be excluded. If they are reimbursed to you by your employer, those amounts are still going to be reported on your W-2. And excess amounts over this, so let's say $5,000, let's say that's the smallest of those four, excess amounts over $5,000 are included in your income. And you will use Form 2441 in order to figure all this out. So, you will incur the expenses, your employer will reimburse the expenses, and then you will use Form 2441 to determine how much of those expenses are actually included in income.

Retirement plan contributions. So, your employer's contributions to a qualified retirement plan are not included in income at the time they are contributed. So, you've got a 401(k), a 403(b) plan, something like that. Your employer makes contributions to those plans on your behalf. Those are not included in your income. Also, the amounts that you have withheld from your pay to be deposited into those accounts, those are called elective deferrals. Those also are not included in your income. In other words, they come out of your income pre-tax. Now, that is unless it is a what's called a Roth type of plan. In a Roth plan, your elective amounts do not come out pre-tax, they come out after-tax. So, you are still paying tax on those. But even with the Roth plan, you do not pay tax on the amount the employer pays into the plan. And we'll talk about all of that in much more detail when we talk about retirement plans.

Incentive stock options. So, what a stock option does is it gives you the right to purchase stock at a certain price. So, what employers will do is they will issue stock options to their employees in hopes that those employees will do a good job, so that the price of the company's stock goes up, and the employee can make some extra money. So, for example, what they will say is, "Okay, we are going to give you a stock option today when the price of the company's stock, let's say it's a publicly traded stock, it doesn't have to be, but it makes the example easier, let's say the stock is selling today for $50 per share, and they say we are going to give you an option to buy our company's stock at today's price, at $50. And that option will be good starting one year from now. So, you can't buy it today at $50, but if you wait at least one year, then at any time after that one year, you can buy the company's stock for $50." So, of course, what the employee is hoping is that a year from now or later, that now the price is worth more than $50, so they can buy it for $50 and they can turn around and sell it for a profit. So, that's what a stock option is.

So, if you get what's called a statutory stock option, which means it meets certain criteria, then there is no income until you actually sell or exchange the stock. So, when you receive the stock option, you don't have any income. Even when you buy the stock, so you exercise the option and buy the stock, still no income. There is no income until you actually then sell that stock. And when you do sell it, it is taxed at capital gains rates, which are more favorable than ordinary income tax rates. And of course, you have to meet those certain rules for it to be statutory. You don't need to worry about that for the exam. Your employer will know whether or not they meet those rules, and they will send this Form 3921. So, that's what your clients will bring in, is the Form 3921 that reports all of these amounts.

Now, if the stock options do not meet that criteria, and they are non-statutory stock options, then generally, those are considered income when received. So, the value of those stock options is income when the options themselves are received. Now, that is assuming that the fair market value of those options can be determined. If it can't be, then it is taxable when those options are exercised, meaning the employee actually buys the stock, or when the option is sold. And again, those gains are at those more favorable capital gains rates.

Clergy. So, if you have a clergy person who is receiving their salary, they report their salary just like everyone else. It is taxable. They are considered an employee for income tax purposes. However, the default is that they are considered self-employed for self-employment tax purposes. In other words, if you have a member of the clergy, like a minister, and they are receiving their salary, they will have income tax withheld from that, but they will not have Medicare and Social Security withheld from that. Instead, they will have to actually fill out a Schedule SE and pay self-employment tax. So, they'll be paying twice as much. Just like we talked about before, they can request an exemption from this treatment. So, they can go to the IRS and say, "Hey, can I just be treated like any other employee and have Social Security and Medicare withheld?" And usually the IRS will honor that, but the minister has to actually request that.

Also, even if they haven't requested that and they're not having Social Security and Medicare withheld, if they perform any non-ministerial services, so anything that's not part of their actually being a minister or a clergy person, then the employer does have to withhold Social Security from that pay. Also, any offerings that they receive for performing marriages or baptisms or funerals or masses, sometimes the people for whom they are performing those services will pay them money, they'll write them a check, they will give them cash, that is income, and they do have to report that. And of course, they have to pay self-employment tax on that as well.

Now, if the person makes the check out not to the individual clergy person, but they make it out to the actual church or temple or synagogue, then it's not included in the clergy person's income. But if they make the check out to the clergy person or they pay them cash, it is included in that individual's income. If the clergy person gives their salary that they receive, or any part of their salary that they receive, back to the church or the religious institution, they still include the salary that they received in income, but then they can take a charitable contribution deduction on their taxes, assuming that they itemize deductions.

If they get a pension or a retirement pay, then that's treated like anyone else, and it's included in income just like it is for anyone else. Housing for clergy members. You do not include in income the fair market value of housing, including utilities, that are provided by the church. It's not included for income tax purposes. And that includes any housing allowance. Now, that has to be a reasonable housing allowance based on the services provided. So, it can't be just some outrageous amount of money that they are paying the person. The person gets it tax-free, it has to be a reasonable amount. And that value, even though it's excluded for income tax purposes, it is not excluded for self-employment tax purposes. So, they do have to pay self-employment tax amounts on that housing. But remember, the housing is excluded for income tax purposes. If you are dealing with these types of clients, you will want to get Publication 517 to learn all the ins and outs of how that works.

Members of religious orders. So, this would be, for example, monks and nuns. They take a vow of poverty, and all of their income is turned over to the order to which they belong. So, if they are working for the order or at an institution that's associated with the order, such as a hospital or a high school or something like that, they do not include their salary in income because it's going straight back to the order. They do not include it in income. However, if they are an employee of an unrelated third party, then you do include their salary in income. So, let's say, for example, you have an order of nuns, and they are nurses, and they work at a hospital that is not associated with their order, and they get a salary for that, and they turn that salary over to the order, they still have to include that salary in their income, and then they can take an itemized deduction for a charitable contribution, just like the clergy person can take. That is different, though, than if they work for a hospital that is associated with their order. In that case, the salary that they get, again, is being turned over directly to the order, they do not have to include it in income. So, that is the distinction there.

A foreign employer. So, this is for people who are working in the United States, but they work for either a foreign government or an international organization, like a relief organization or one of these type of nonprofit type of organizations. If they are a U.S. citizen, then they include their salary in income just like they would for any other type of job that they have. They will also have to pay self-employment tax. So, they'll have to fill out this Schedule SE to report their self-employment tax, even though they're not self-employed. Why? Because these foreign governments and foreign organizations, they're not part of our Social Security system, so they're not going to withhold Social Security and Medicare from the pay. So, that U.S. citizen has to pay those amounts by paying self-employment tax.

If it is a non-citizen who works for one of these international organizations, then that amount that they get, the salary that they get, is not taxable at all. So, they're a non-citizen who works for an international organization, they are working in the United States, but that income is not taxable to them. If they are a non-citizen of the United States who works for a foreign government instead of an international organization, then usually it's the same way, it's not taxable to them. However, we do have to look at these exceptions. Their work that they are doing has to be just like the work that U.S. citizens do in foreign countries. So, they're doing something comparable to what we have people doing in other countries. That's the first thing. And secondly, the foreign government for whom they are working has to give an equal exemption in their tax law for U.S. citizens who are working there. So, they have to have this reciprocity between the United States and that other country. So, as long as those things apply, then that non-citizen who works for that foreign government does not have to pay United States income tax on their salary.

Members of the military. Their salary is treated just like anybody else. Their retirement pay is taxed just like anybody else as a pension. And any differential pay that they get that we talked about before is included in income. Now, there are some veterans' benefits that are not included in income, and so that's all the things you see listed there on the screen: Education and Training allowances that they get, disability compensation, grants for homes that are designed for wheelchairs or grants for cars that are for veterans who have lost sight or limbs, veterans' insurance proceeds and dividends, not included in income. Interest on insurance proceeds that are on deposit with the Veterans Administration, dependent care assistance benefits that they receive, death gratuities paid to a survivor, compensation under a work therapy program, or a bonus for working in a combat zone. Those things not included in income. And you will want to remember, especially this combat zone one, that does come up sometimes on the exam.

Volunteers in various organizations. You don't need to spend a lot of time on this, just kind of remember that you heard this. If you're in the Peace Corps, the living allowance that you get for housing, utilities, etc., is excluded from income. There are some allowances that could be taxable if those are allowances for things like domestic help or laundry or entertainment, those would be. But the main thing to remember is that the living allowance that they get for working in the Peace Corps, not included in income. Volunteers in the VISTA program, Volunteers in Service to America, their allowances for meals and lodging are included in income. And then the National Senior Services Corps programs, you do not include those amounts in income. So, that's the Retired Senior Volunteer Program, the Foster Grandparent Program, and the Senior Companion Program.

Volunteer tax counseling. This is something you might be interested in. You will have the opportunity as a tax preparer to do volunteer tax work for various individuals. So, you've got Tax Counseling for the Elderly. You do not include any expense reimbursements in income. There is this VITA program, Volunteer Income Tax Assistance program. You can deduct unreimbursed expenses as a charitable contribution for those. Any volunteer firefighters and emergency medical responders, you do not include any payments that they receive up to $50 per month. And if they get a break or a rebate on their property taxes, that is not included in their income.

Next, let's talk about injury and illness income. So, we've been talking about the income for people who actually work, but what about when you're not able to work? How do we include that income? So, first of all, is disability pensions. If you retired on disability, then you include the pension received under a plan paid for by your employer. So, in other words, it is taxable. Any amounts that you received until retirement age are reported as wages, and after retirement age, any amounts are reported as a pension. So, you will get either a W-2 if it is to be reported as wages, or you will get a 1099-R if it is to be reported as retirement income.

For a military disability pension, you exclude it if it is based on a service-connected disability. You include it if it's based on years of service. So, if they determine the amount of the pension based on how long you were in the military, then that is included in your income. If it is a mix of your disability and years of service, then you only include the portion in your income that is based on the years of service. So, what they're saying is, if it's based on years of service, then that's more like a pension than disability, so it's going to be included in income. So, you can only exclude the amount that is based on the disability.

Long-term care insurance proceeds. So, long-term care insurance is something that you buy when you're healthy, so that if you ever end up in a nursing home, then the insurance will cover the cost of that nursing home. So, if you are collecting on that, so you are now in the nursing home, you can exclude up to $410 per day of those amounts that you are receiving from that long-term care insurance. And interestingly, this is actually less than was allowed in 2023. In 2023, it was $420 per day. Usually, we have inflation adjustments that cause amounts to go up, but in this case, the amount actually went down. So, for 2024, it is only $410 per day, and that is a number you will want to remember for the EA exam. And in order to report this, you will use Form 8853. So, you do have to report those amounts, even though they are excluded. And then if you receive any amounts in excess of that $410 per day, then that will show up as being taxable income, and that will be shown on this Form 8853.

Workers' compensation. You exclude from income payments that are received for an occupational sickness or injury. The exclusion does not apply to retirement benefits that are based on age or length of service, even if the person retired due to an illness or an injury. And if you return to work on light duty, then the salary that you are receiving is still included as income. So, you're only excluding the payments that are received for the sickness or the injury itself.

Other injury or illness compensation. You are going to exclude payments for all of these things: compensatory damages for illness or injury, whether lump sum or periodic, benefits received under an accident or health insurance policy which either you paid for or your employer included in your income. So, these amounts, what are those commercials with the duck, Aflac, I think, and there's lots of other companies that have similar type of payments, they will make a lump sum payment to you if you get hurt, if you're in an accident, and those amounts are not going to be included in income as long as you paid for it. And usually that's

How they are paid for. They're paid by a deduction from your payroll from your salary.

Disability benefits for a loss of income or earning capacity under no-fault car insurance policies. So, some states have what's called no-fault car insurance. You probably know whether or not your state has that. Well, if you receive disability benefits under one of those policies, not included in income, compensation for permanent loss or loss of use of a part or function of your body or for permanent disfigurement. So, it must be based only on the injury and not on absence from work. So, if you're getting reimbursed because you had to miss work due to the injury, those amounts are included in income. But if you are actually being compensated for the injury itself, that is not included in income. And it is not included in income even if your employer was the one who paid for the policy.

And then reimbursement for medical care. So, if you've got health insurance and you pay for an expense and then your medical insurance reimburses you, that is not included in income. Or if you have medical expenses due to an accident or something and someone else's insurance policy pays you back for those, not included in income.

Next type of income we'll talk about is interest income from various sources. So, in general, any interest you receive or that is credited to your account and can be withdrawn is taxable income. And this includes foreign source interest income. Often, this will be reported on a 1099-INT, but again, it doesn't have to be, and you still have to include it in income even if it's not.

Interest that is received as a beneficiary of a trust is also taxable. That will be reported on a K-1 from the trust. Property that you give to a child under the Model Gifts of Securities to Minors Act or the Uniform Gifts to Minors Act or similar law becomes the child's property, and any income is taxable to the child. So, let's say you have a small child and you want to give them some money. So, you go to a bank and you say, "I want to set up an account under the Uniform Gifts to Minors Act for $10,000." And the bank knows how to do this. And then you put that $10,000 in, and now that earns interest. That interest belongs to your child, not to you. So, the interest is taxable to the child.

As the tax preparer, the way you will know this is you'll get the 1099 and you look at the social security number. If it is the child's social security number, then it belongs to the child. If it is the parent's social security number, then you can assume it belongs to the parent. Now, if the parent thinks that there's been a mistake, then you can contact the bank and you can try to work that out. But in general, you can look at the social security number, and that will tell you who it belongs to. But for purposes of the EA exam, just remember, if the property was given to the child under any of these acts, then the income from that belongs to the child.

Now, some interest is not federally taxable, such as interest on municipal bonds. We call these muni bonds. Not taxable. We'll talk a little bit more about those later. Dividends received from a mutual fund that holds muni bonds, also not taxable. Now, those will be called dividends, so you'll get a 1099-DIV, DIV, from the mutual fund, but they are still considered interest. But in this case, they are not taxable. So, it's not taxable interest. It'll actually be in a separate box on the 1099-DIV that says it is municipal and it is not taxable.

Interest on VA Veterans Administration dividends that are left on deposit with the VA, not taxable. And interest inside of IRAs is not taxable. So, if you set up an IRA, that IRA is going to earn various types of income. It could earn interest, and that is not taxable, at least not currently. It could be taxable one day when the person retires and takes the money out, but it is not taxed year-to-year as it is earned.

Interest from banks and loans you make to others and other sources are generally going to be taxable interest. So-called dividends from credit unions. So, they call them dividends, but it's actually interest, and they will issue you a 1099-INT. So, that is taxable as interest income. Dividends from money market funds, such as mutual funds, those are taxed as dividends, and you'll get a 1099-DIV, and you will count those as dividends.

Interest on certificates of deposit are taxable when received or when available without a substantial penalty. So, with a certificate of deposit, you're going to deposit your money with a bank or the financial institution, and you're going to do so for a certain number of months or years, and the deal is you can't get that money out for that number of months or years. So, let's say you put it in, it's for two years, you're not allowed to get that money back for two years, at least not without paying a substantial penalty. If you really need the money, you can get it, but you're going to have to pay a penalty to do that. So, what they're saying is, as long as those rules are in place, you're not going to have to pay tax on that interest until you actually receive it. So, it's consistent with being a cash-basis taxpayer.

Any gifts that you get for opening an account are treated as interest. So, sometimes you'll see these deals, "Hey, open an account with us and we'll give you $200." And that $200 will be considered interest income. Non-cash gifts that you get, if they are worth more than $10, if you are depositing less than $5,000, if they're worth more than $10, they are going to be treated as interest income. So, this is the stereotypical toaster that you might get for opening a bank account. If it's worth more than $10 and you're depositing up to $5,000, then that will be reported as interest. If you're depositing $5,000 or more, then the limit is $20.

Other types of taxable interest: Interest on insurance dividends that are left on deposit with an insurance company. Interest on U.S. bonds or obligations. So, sometimes people confuse municipal bonds with U.S. bonds. If you have a municipal bond, that we'll talk about in a little while, those are not federally taxable. The interest is not taxable on your federal tax return. However, U.S. bonds, United States bonds, bills, and Treasury obligations, etc., the interest on those is taxable on your federal tax return.

Also, interest on tax refunds. So, if you get a refund from the federal government or a state government or anyone else, and they pay interest on that, then that interest is taxable income. Interest on any condemnation award is taxable. Interest on the portion of an installment sale is taxable. So, we'll talk about installment sales in later videos, but if you have an installment sale, part of the amount that you receive is going to be considered interest, and you do have to pay on that. Interest on an annuity contract is taxable. Interest on frozen deposits. So, for instance, if there's a bank failure, the government will come in and they will freeze all the deposits, and nobody can get their money back. However, they may, once they freeze that, they may actually pay interest on that. That is considered taxable.

And then below-market loans. So, this is usually going to be between related parties. If you lend money to someone at little or no interest, then you may have to impute interest in line with market interest rate. So, impute means you have to act as if you received the interest, even though you didn't actually charge or receive any interest. Now, this is only going to be for larger loans. This is not if you lend your buddy $50 and they don't pay you any interest. We're not talking about that, but we're talking about larger loans, and usually it's going to be between family members. They just want to make sure people aren't playing games and pretending to lend money when they're really just giving the person money, and they're trying to avoid something called the gift tax. And so they're going to say, if you are lending money to someone and you're not charging interest, then we're going to make you include in your income interest as if you were charging interest.

U.S. savings bonds. As we said, generally the interest is included in income in the year that it was received. For a special type of bonds called Series HH bonds, they pay interest twice a year plus a deferred portion that is income when received. Series E and I bonds, the interest pays when those bonds are redeemed. So, they are sold at a discount, and the difference between the purchase price and the redemption price is interest. So, for example, maybe you have a Series E bond, a Series EE bond, that has a face value of $1,000, but you're able to purchase that at a discount. So, let's just say you purchase it at $800, and then you can cash that bond in at some date in the future, let's say it's five years from now. Now, you can cash that bond in, and when you cash that bond in, you will get $1,000 back. So, you paid $800 for it, you cash it in five years later, you get $1,000 back. That is going to be considered $200 of interest in that year that you receive the money. Now, you can elect instead, if you want to, to count $40 a year for five years, rather than counting the whole $200 at the time that you receive it. Most people don't do that, but that is an election you can make if you want to.

If you transfer ownership of a bond before redemption, then you do have to include in income all the interest that has accrued to that point. So, in other words, let's say you have one of these Series EE bonds and now you sell it two years after you bought it. So, you're not redeeming it, you're selling it to someone else, and presumably they are going to redeem it. Well, you do have to include two years' worth of that interest in your income at the time that you sell it. So, that's how that works.

Education Savings Bond Program. You may be able to exclude interest from certain savings bonds if you paid qualified higher education expenses during the year of redemption. This applies to interest on Series EE bonds issued after 1989 and Series I bonds. If those bonds were issued in your name or your and your spouse's name, and you must be at least 24 years old before the bond's issue date. So, you have to be 24 before the date that the bonds were issued.

So, let's look at an example. Bob bought a Series EE bond in 1998 when he was 30 and had the bond issued in the name of his daughter Emily, who was 2 years old at the time. The bond was redeemed in 2024, and the proceeds were used to help pay for Emily's college costs. In this case, neither Bob nor Emily qualifies for the exclusion. Why? Because the bonds were issued in Emily's name. Remember, it had to have been issued in the name of someone who was at least 24 years old. Was Emily 24 years old when the bonds were issued in 1998? No, she was only two. So, therefore, Emily is going to have to include the interest in income when she redeems that bond. What should have Bob done? If he had been thinking about it, he should have had the bonds issued in his name rather than in Emily's name.

U.S. Treasury bills, notes, and bonds. As we said before, interest is taxable for federal income tax, but it is not taxable for state and local income tax. If the bonds are sold between interest dates, then the seller has to treat part of the sales price as interest income, and the buyer does not have to include that amount of that accrued interest income when the interest is received. So, again, you've got it being sold before the interest is paid. Each person has to pay tax on the interest for the amount of time that they held the bond. So, that's what this rule is doing. It's making sure that each person is having to pay tax on the interest that they earned while they held the bond, and they're not having to pay tax on the interest for the period of time that they did not own the bond.

State or local government obligations. These are those muni bonds, the municipal bonds that we have been talking about. Interest on bonds that are issued by a state, the District of Columbia, a possession of the United States, or any of their political subdivisions is not taxable at the federal level. So, what are we talking about? States, cities, counties, etc. If they issue bonds, the interest on those bonds is not taxable at the federal level. Usually, it's not taxable at the state level either for the state in which they were issued, but you do have to check your state law. And of course, the EA exam is covering federal tax, not state and local tax, so you don't have to worry about it for the exam.

Interest on bonds that are issued after 1982 by an Indian tribal government, also not taxable. And if you file a tax return, you have to report this interest even though it is not taxable. So, there is a spot on the return where you report the municipal interest, even though you don't have to pay tax on it.

Interest on life insurance proceeds. So, life insurance proceeds themselves are generally not taxable. However, if you receive that amount in installments, a portion of each payment is generally going to be interest, and that portion is taxable. And if you buy an annuity with the life insurance proceeds, then the annuity payments are going to be taxed as a pension and annuity income as if from a non-qualified plan rather than as interest income. So, an annuity means you are getting a series of periodic payments. They could be monthly, quarterly, annually. So, if you're receiving those types of payments, then that will be taxed as a pension or annuity.

Original issue discount. When a debt instrument, such as a bond, is issued at one price and the redemption price is higher, this is considered original issue discount. We saw something similar when we were talking about the bonds, and we said if you bought the bond for $800 and five years later you redeemed it for its face value of $1,000. So, this is the same type of concept, except that these rules, the original issue discount rules, don't apply to U.S. savings bonds. But if you have this original issue discount, this OID, it is generally considered interest and it must be paid as it accrues each year, even though no interest is actually received.

So, for example, this will be just like our savings bond issue, except we're talking about a company bond, a corporate bond, rather than a U.S. savings bond. So, a company issues a zero-coupon bond, that just means it doesn't pay any interest. So, they issue a zero-coupon bond with an issue price of $800. The bond's face value is $1,000, which will be paid at maturity five years from the date of issue. There is $200 then of original issue discount. That's the difference between the $1,000 face value and the $800 issue price. So, that $200 is original issue discount, and it must be partially recognized each year. So, you have to recognize $40 each year. Unlike the U.S. savings bond, you cannot just wait and include the entire $200 in the year that it was received. So, this is another exception to the cash basis type of accounting. You have to include the income as it accrues each year rather than waiting to include it all when it is actually received.

Now, original issue discount does not apply to tax-exempt obligations. Does not apply to U.S. savings bonds, as we said. It does not apply to short-term debt instruments with a maturity of one year or less, because what difference does it make? They're being issued and redeemed within one year. So, it doesn't apply to that. Does not apply to loans between individuals, as long as all of these conditions are true: that the loan was not made in the course of a trade or business, that the amount of the loan or the total loans between those individuals is not more than $10,000, and it's not being done in order to avoid federal income tax. And OID rules do not apply to a debt instrument that is purchased at a premium. In other words, if you're paying more than the face value of the bond, then you don't have to worry about OID.

If you have any OID, you will usually receive a 1099-OID if it is for $10 or more. If you have de minimis OID, there's that phrase again. So, you've got a very small amount of original issue discount, you can ignore that OID. If it is less than 1/4 of 1% of the stated redemption price at maturity multiplied by the number of full years from the date of original issue to maturity. So, let's look at an example. Roberto bought a 10-year bond with a stated redemption price at maturity of $1,000, and it was issued at $980. So, it has OID of $20. So, if you take the $1,000 times 1/4 of 1% (.0025) times 10 years, that equals $25. Because the amount of the OID is $20, it's less than this de minimis calculation of $25, you can ignore that original issue discount. It is treated as zero. So, if he holds that bond to maturity, he will get $1,000 for it, and at that time he will recognize that $20. But he doesn't recognize it as interest, he recognizes it as capital gain, which is taxed at more favorable tax rates.

Reporting interest income. So, you're going to report interest income on line 2B of your tax return, the 1040, and you may also have to complete Schedule B. And you have to complete it if any of the following apply. I'm not going to go through all of these, but I'm going to look at a couple of them. So, first of all, if your taxable interest and dividends combined is greater than $1,500, then you have to complete a Schedule B, where you list out the specifics of where that interest and those dividends came from. And then going down to this bottom one, if you received a distribution directly or indirectly from a foreign account, the IRS is very leery and concerned about foreign accounts. So, no matter how much it is, if you received a distribution of interest from any foreign account, then you have to fill out a Schedule B, even if it's not $1,500. And then you do have all of the other things that you can read about later about when you have to fill out a Schedule B.

Next, let's talk about dividends. So, dividends are distributions from a corporation to its stockholders or a mutual fund to its owners. So, the classic idea of dividends is you own a stock in a company. Let's say it's a publicly held company. Doesn't have to be, it just makes it easier to talk about. So, you own a stock in a company, and the company operates its business, it earns a profit, and as an owner of that company, because if you own part of the stock, you are one of the owners of the company, so you are entitled to share in the profits of that company. And the way that they share those profits is by issuing dividends. So, you get a dividend that is taxable income. Those will be reported to you on a form 1099-DIV.

Now, you can also see mutual fund there. So, the way a mutual fund works is lots of people put their money together, they give it to the mutual fund company. The mutual fund company then goes out and buys all of those stocks and those corporations. They can buy other things too, but for this example, they're buying stocks in these companies. And then when those corporations issue those dividends, they are going to issue those to the mutual fund company because the mutual fund company is the one that actually owns the stock. They are actually the stockholder. Then the mutual fund company will turn around and issue those dividends to you as the owner of the mutual fund. And then they will send you your 1099-DIV.

You can also sometimes find dividends reported on some K-1s from partnerships or S corporations or from estates and trusts. And you do have to fill out the Schedule B if you have more than $1,500 again, combined interest and dividends, or if you received any dividends as a nominee for someone else.

Most dividends are considered what are called ordinary dividends, which means they are taxed at ordinary income tax rates. You should assume that dividends are ordinary unless they are reported to you as being what are called qualified dividends. Qualified dividends are taxed at capital gains rates instead of ordinary income tax rates. And as we'll see in the next video, capital gains rates are lower than ordinary income tax rates. So, it's a good thing if they are considered qualified dividends.

In order to be qualified, they must be paid by a U.S. corporation or a qualified foreign corporation. They cannot be of a type that is deemed to be not qualified, and there is a certain holding period of the stock that must be met that we will talk about. So, what is it to be deemed not qualified? Well, if you were anything on this list, then the dividends will not be qualified. Capital gain distributions are not considered qualified dividends. Dividends that are really interest, such as those that are paid by credit unions and mutual savings banks, etc., those are not qualified because they're not actually dividends. Dividends from a tax-exempt organization are not qualified. Dividends paid on shares held by an employee stock ownership plan or an ESOP, not qualified. Dividends on any share of stock to the extent you are obligated to make related payments for positions is substantially similar or related properties. In other words, if you are getting a dividend, but one of the conditions of you're receiving that dividend is that you have to then turn around and buy more stock, then that is not considered a qualified dividend. Any payments that are made in lieu of dividends, if you know or have reason to know that they are not qualified. And any payments that show up on a 1099-DIV as qualified, if they're from a foreign corporation and you know or have reason to know that they are not actually qualified.

The holding period. Remember, we said there has to be a certain holding period. So, the IRS does not want people coming in, buying a stock one day, getting the dividend the next day, and then turning around and selling the stock the day after that and getting to treat that dividend as a capital gain, as a qualified dividend, rather than as an ordinary dividend. So, they're giving you a break on the tax rate by taxing these qualified dividends at a lower capital gains rate. So, they want to make sure that you've held the stock for a certain minimum amount of time in order to get that benefit. That's where this holding period comes in. So, the rule is that you must have held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date. So, in other words, you have this date called the ex-dividend date. So, you look at 60 days before that date, you look at 60 days after that date, that's 120 days, and then you have the ex-dividend date itself. So, that's 121 days. During that 121-day period, you must have owned the stock for at least 61 days in order to get this special qualified dividend treatment.

So, what is the ex-dividend date? That is the first date following the declaration of a dividend on which the buyer of a stock is not entitled to receive the next dividend payment. So, what will happen is a corporation will come out and announce in advance that they are going to be making a dividend, and they will say, "Anybody who owns the stock on this date will be entitled to receive the dividend, but if you don't acquire the stock until after that date, then you are not entitled to receive the dividend." So, that is the ex-dividend date. So, you just have to make sure that if you want this qualified treatment for the dividends, that you own the stock for at least 61 days during that 121-day period.

Now, for preferred stock, usually dividends will be paid, for instance, quarterly. That's a very common time frame that dividends are paid. But there can be dividends paid on different time periods. And specifically for something called preferred stock, they may pay dividends on an irregular type of time period. So, if you have dividends on preferred stock, and those dividends are for periods that are longer than 366 days, so it's going more than a year between payments of dividends, then instead of the normal 121-day period, you have a 181-day period. It is 90 days before the ex-dividend date, 90 days after the ex-dividend date, plus the ex-dividend date itself. So, it's the same idea, it's just a longer time period. In practice, most of the time you're going to be dealing with this first example, which is the 121-day period.

Dividend reinvestment plans. So, some corporations and mutual funds will offer this service, and they, what they will do is they will let you use the dividends that you are supposed to receive to purchase more stock rather than receiving them as cash. So, in this case, they won't send you a check for the dividend. You'll sign up for this program in advance, and then they will just take the dividends that you were supposed to receive, and they will just buy more shares of the stock or more shares of the mutual fund instead. Those dividends must still be reported as income because you could have received the cash, you just chose not to. So, remember constructive receipt. You could have gotten the money, you didn't. So, the IRS is going to treat this as if you had received the cash and then you just turned around and bought more shares.

Stock dividends. So, sometimes a corporation, rather than paying cash for their dividends, will just issue more stock instead. If you have that, that is not taxable. Now, the exception is if you could have received cash and you just chose to get stock. But if they didn't give you a choice, if they just said, "Hey, we're not issuing cash for this dividend, we are just issuing more shares of stock," in that case, you do not have to pay any tax on that stock dividend.

Constructive dividend. So, a distribution from a corporation, and we're talking primarily here about a C corporation. We'll talk all about that and in more detail about all of these things in Part Two, but just for now, for Part One, just understand that this can exist. So, a distribution from a corporation to a shareholder that is not called a dividend can sometimes be considered to be a dividend for tax purposes. So, this is going to result in dividend income to the shareholder, and no deduction for the corporation. So, when a corporation pays a dividend, that is not a tax-deductible expense. So, they're paying out the dividend, the corporation does not get a deduction for paying that dividend, but the shareholder, of course, does have to include the dividend in their income.

So, what will happen sometimes is with closely held corporations. So, we're not generally talking about big publicly held companies, we're talking about closely held private corporations. Sometimes the owners of those corporations will try to kind of play games and reduce their taxes, and they'll do it by making payments that they don't call dividends, but in effect, they really are dividends. And so this is just letting you know that in those cases, those will be what are called constructive dividends, and they will be taxable.

So, for example, if the corporation pays the personal expenses of one of the owners. Well, of course, a personal expense of the owner is not a tax deduction for the corporation. So, if they pay the personal expenses of the owner, that is considered a dividend to the owner. The owner has to pay tax on that. Or if there is corporate property, it's owned by the corporation, but the shareholder uses that property for their own personal purposes. So, maybe the corporation owns a retreat house in the mountains, and the owner vacations in that retreat house for six weeks out of the year. They would have to reclassify the value of that as a dividend. Or if the corporation pays off the personal debts of the owner, that would be considered a dividend.

If the corporation pays excessive compensation to a shareholder or one of their family members. So, obviously, if a shareholder is working in the business, they are entitled to reasonable compensation. So, they get their salary. That salary is deductible by the corporation, of course. The shareholder, the employee, includes that salary in their income. But sometimes what these privately held corporations will do is they will pay the owner an outrageously high salary. Why would they do that? Because salary expense is deductible. If they paid a dividend, it would not be deductible by the corporation. So, they will try to pay this really large salary, take the deduction for the salary, and the IRS steps in and says, "No, the amount that's above a reasonable salary is not going to be allowed to be called salary. Instead, we are going to call that a dividend." And sometimes this happens not just with the shareholder, but with a family member. They may have a family member, say their spouse, that doesn't even work in the business, but they pay them this salary as if they did. Well, that would get reclassified from being a salary to being a dividend.

And then the last example we have here is a purchase or rental of an asset from a shareholder higher than fair market value. So, maybe the shareholder owns a building, and they rent that to the corporation. Well, they can do that, that's perfectly fine, but they have to pay the corporation has to pay a normal fair market value rent. They can't artificially inflate the amount of rent in order to take a rent expense rather than paying a dividend. So, if they try to do that, then the IRS will reclassify the excessive rent as a dividend. Similarly, if the shareholder owns an asset and they sell it to the corporation, that's fine, they can do that, but the corporation needs to pay a reasonable price for that asset. They can't pay an artificially high price in order to get more money over to the shareholder. If they do that, the excess will be considered a dividend.

Now, let's talk about other types of income. First of all, business income. Of course, all of Part Two of this course is going to talk about business income and how that is computed. But for Part One, you need to know that income from a sole proprietorship is reported on Schedule C of the Form 1040. Income from a self-employed farmer is reported on Schedule F. And income from rental real estate is reported on Schedule E, page one of the Schedule E. And all of these, again, will be covered in Part Two when we talk about businesses.

Partnership and S Corp income. So, partnerships and S corporations are generally not taxable entities themselves. In other words, the partnership and the S corporation, they do not pay taxes at the partnership or corporate level. Instead, any income or loss that they have passes through to the owners, to the partners or the shareholders, based on their ownership percentage. And then the partnership or S corporation will issue a K-1 to the owner that shows the amounts that those owners need to report on their 1040. So, the ordinary business income that they get from running the business, that is reported on page two of the Schedule E. There are some items, though, that are called separately stated items. So, those will be things such as charitable contributions or something called a Section 179 deduction. Those things may be deductible by the individual on their Form 1040, or they may not be, depending on the individual's tax situation. But those will be separately reported on the K-1. It can also show other items, including things that affect basis and amounts that are eligible for the qualified business income deduction. So, there can be these various items on the K-1 that you will need as the tax preparer in order to prepare the owner's Form 1040.

Estate and Trust income. Unlike a partnership or an S Corp, an estate or trust may have to pay tax. Depends on the type of entity that it is. Sometimes, though, the beneficiary has to pay tax. So, the beneficiary may have to pay tax on an item, or the trust may have to pay tax on it, but they don't both have to pay tax on the same items. But you will get a K-1 that shows the amounts that the beneficiary needs to include on their tax return. If you are the beneficiary of a trust that is required to distribute all of its current income, then you have to include the income in your taxable income even if you don't actually receive it. So, there are certain types of trusts that are required to distribute all of their income annually. Sometimes, though, they don't actually distribute it, but even if they don't actually distribute it, you still have to pay tax on it as if they did. It's kind of like constructive receipt. Otherwise, if it's not that type of trust, then you're going to pay tax on whatever amounts are distributed or credited to your account. But losses from trusts and estates are not deductible by the beneficiaries. That's different than an S Corp or a partnership. But those have losses, they can flow through to the individual, and those individuals can, if they meet certain requirements, take those losses on their tax return. But that is not the case with a trust or an estate. And as we said, you'll get a K-1 from that trust or estate showing those amounts that need to be reported, and those are reported on page two of Schedule E.

Royalties. Royalties typically will come from oil, gas, or mineral properties, and from copyrights or patents. They will usually be reported on a 1099-MISC or on a Schedule K-1. And the taxpayer reports those on Schedule E of their Form 1040. If those are received by someone who is in business as a self-employed artist, writer, inventor, etc., then that is business income, and it will be reported on Schedule C rather than on Schedule E. So, if you are an author and you've got a copyright and you're receiving income on that because of that copyright, then you'll put that on Schedule C rather than on Schedule E.

Rents from personal properties. We're not talking about real estate here. Real estate will cover in Part Two. But if you've got rents from personal property, such as equipment or vehicles, then if you're in the business of renting properties, then that's a business, and you'll put it on Schedule C. But if you're not in the business, then you will put it on Schedule 1 as other income. So, let's say, for example, you've got some special tractor that you use for yourself, and you don't usually rent it out, but once in a while you've got a friend or somebody who wants to use it, and they pay you a little bit of money for using your tractor. Well, that is taxable, but you would just report that as other income on your tax return.

Bartering. So, bartering is an exchange of property or services, and you have to include in income the value of any property or services that you receive. So, what is the value of that property or services? Well, if you both agree on the value ahead of time, then that will be accepted. The IRS will accept that. Often, you will get a 1099-B for this. So, if you exchanged property or services through a barter exchange, then you'll get a 1099-B that'll show the value of the property or services that you received during the year. Generally, this is going to be business income, and you are going to report it on Schedule C.

So, what happens with these exchanges is you have a service that you provide, and a lot of other people who are part of the exchange have services that they provide. So, one person might be a lawyer, one person is a computer coder, another is a website designer, another is a handyman. And so you all exchange. So, if you provide a certain amount of legal services as a lawyer, then you'll get credits, and then you can use those credits to use the computer coder, and then that computer coder can do work for you, and they'll get credits for the work that they do. So, all these people, instead of paying each other money, they are simply exchanging services.

So, let's look at a couple of examples. Example one: You are a self-employed attorney who performs legal services for a client that is a small corporation. The corporation gives you shares of its stock as payment for your services. You must include the fair market value of the shares in your income on your Schedule C in the year that you receive them.

Example two: You are self-employed and a member of a barter club. The club uses credit units as a means of exchange. It adds credit units to your account for goods or services you provide to members, which then you can use to purchase goods or services offered by other members of the barter club. The club subtracts the credit units from your account when you receive goods or services from other members. You must include in your income the value of the credit units that are added to your account, even though you may not have actually received any goods or services from other members until a later tax year. So, again, it's constructive receipt. You have received those credits, you could use them now if you want to. Just because you choose to hold on to them and use them later doesn't mean you get to avoid tax. You have to include those in taxable income when they are received.

Cancelled debts. Generally, if a debt you owe is forgiven, you must include that canceled amount in your income. If it is a nonbusiness debt, then you report the canceled amount on Schedule 1, line 8C. If it is a business debt, you report the amount on Schedule C or Schedule F if you are a farmer. If you have a debt that is forgiven by a government agency or a financial institution, then you will receive a 1099-C if it was $600 or more. So, for example, let's say you've got a bunch of credit card debt, and you go to the credit card issuer and you negotiate with them, and you say, "Look, I've got all this debt, I can't pay it back, I need some help here." And that credit card issuer agrees to restructure your debt. They say, "Okay, if you agree to make payments of X amount per month, then what we will do is we will reduce the amount you owe. We will reduce that debt for you." If they do that, then they will issue a 1099-C, and that is taxable income.

There are certain exceptions to this, though, when you do not have to include it in income. So, first of all, if it is a student loan that is forgiven, do not have to include it. If the debt was discharged in bankruptcy, you do not have to include it. Or if you were insolvent. So, even if you weren't technically in bankruptcy, if your liabilities exceeded your assets, then that debt discharge income is not taxable. Also not taxable if it is a qualified farm debt, if it is qualified real property business debt, if the cancellation is intended as a gift, or if it is qualified principal residence indebtedness. Now, all of these categories and exceptions have different qualifiers, but you don't need to know those for the exam. For the exam, just know these general categories. And if you want to know the details, then you can do the research on those.

Hosting a party. If you host a party at which sales are made, any gift or gratuity that you receive is included in income at its fair market value. So, you've got these parties that people have in their homes where they sell kitchen gadgets or purses and clothing, all these types of things. If you host one of those and you get a gift in exchange for hosting it, that is income to you. Although you are also allowed to deduct half of the reasonable cost of any meals that you provided as the host of that party.

Life insurance proceeds. As we said before, generally life insurance proceeds are not taxable. So, this is actually a fairly common question you will get from clients and from other people who know that you're a tax preparer. They will say, "Hey, my parent or grandparent died, I got this life insurance proceeds, how much of that is taxable?" And the answer is none. It is not taxable. Now, if you receive that amount in installments, some of what you receive may be interest, and in that case, the interest portion would be taxable. If you cash in a cash value policy, so you're still alive, you've got a cash value life insurance policy, you cash that in, any amount that's in excess of what you contributed to that policy will be income to you, and it will be reported to you on a 1099-R. If you receive accelerated death benefits, so sometimes if you are terminally ill, the insurance company will pay you the amount of the policy while you are still alive, and generally you can exclude that from income. Now, you have to actually be terminally ill, and you have to be able to prove it and all of that. You can't just declare yourself terminally ill, but if you meet all that criteria, then you do not have to include that amount in income.

Recoveries. A recovery is a return of an amount that you previously deducted or took a credit for in an earlier year. Most common is that these are refunds or reimbursements and rebates of deductions that were itemized on Schedule A. You could also have recoveries of non-itemized deductions, such as payments on previously deducted bad debts, and recoveries of items for which you previously claimed a tax credit. If the payment and recovery happen in the same year, then you don't have to worry about it because it's all in the same tax year, so there is no tax effect. You can ignore it. But if the deduction happens one year and the recovery happens a later year, then you do have to include that in income.

So, let's look at a couple of examples. Example one: In 2023, you itemized deductions, including state income tax payments of $8,000. And April of 2024, you prepared your 2023 state income tax return, and as a result, you received a state income tax refund of $500. You have $500 of taxable income in 2024. You deducted it. That $500 was part of the $8,000 that you deducted on your tax return. So, since you got a tax deduction for it, and you are now getting a refund, that refund is taxable income to you.

Example two: Same facts as example one, except in 2023, you didn't itemize deductions, you took the standard deduction. In that case, the $500 is not included in income because technically you did not deduct it. You did not itemize your deductions. So, that $500 was never deducted, so it is not included in your income. And then I have the note there: Federal income tax payments are not deductible, therefore any federal tax refund is not taxable. So, you get a federal tax refund, that is not taxable income because you were not able to deduct that in the first place.

Unemployment benefits. Unemployment benefits are taxable income. They will be reported to you on a 1099-G. You may remember in 2020, there was an exception due to COVID. They allowed a certain amount, like $10,200 or something like that, that they allowed you to receive tax-free. But that only applied to that one year. So, we're talking about the 2024 tax year here. So, any unemployment benefits received are taxable income.

Welfare and other public assistance. Government payments received based on need are not taxable and are not included in income. If they are payments for services performed, then they are taxable. If those payments are fraudulently received, so you're scamming the welfare system, those amounts are taxable. Again, this is a crime. Or illegally received income, it is taxable.

Disaster relief. You do not include in income amounts that are received if you are a victim of a federally declared disaster or terrorist act. So, sometimes the government will come out and say, "Okay, we're going to give everyone in a certain area that was affected by this disaster a lump sum payment." That amount is not included in income. And there are certain specific disasters that have been named that the amounts that are received for them are not taxable. And this is new for 2024. So, there was this train derailment in East Palestine, Ohio, that caused lots of problems, and there were payments that were made as a result of that. Those are not taxable. And there are qualified wildfire relief payments that were made. Those also are not taxable.

Next, let's talk about a hobby or an activity that is not for profit. We're going to go into more detail about this in Part Two, but we do need to know for Part One that if you have income from a hobby, then that is

reported as income on Schedule One. That is taxable income, and the deductions are limited to the amount of income. So, you can't have a loss from a hobby. You can have income, but you cannot have a loss. However, you can only take those deductions if you itemize deductions. And most people these days, because the standard deduction is so large, I think it's more than 80% of taxpayers do not itemize deductions. So, this really seems unfair to me. If you have a hobby and you've got income from that hobby, you have to report the income and you have to pay tax on it. But unless you itemize deductions, you're not allowed to decrease that income by the amount of your deductions. And most people don't itemize deductions. So, I think people are really getting a raw deal here, having to pay tax on this income.

However, the EA exam is not, not going to test you on what Tom thinks is fair. They are going to test you on what is the tax law. And the tax law is what it is. You have to pay tax on the income, and you can only take the deductions if you itemize.

So, here's an example. Cheryl grows tomatoes in her garden primarily for recreation and personal use. But in 2024, she had a bumper crop. So, she sold some of those tomatoes to some neighbors and friends. That income received is taxable to her as other income. And since she takes the standard deduction, no expenses involved in growing or selling the tomatoes are deductible.

Alimony, or sometimes called spousal support, for divorces with alimony payments that are entered into or modified after 2018, that alimony is not included in income and it is not deductible by the one who paid it. For divorces prior to 2019, so 2018 or earlier, the alimony generally is included in income and it is deductible by the one who paid it. So, you will want to remember this date, the 2018, 2019 date. If it was after 2018, so it was 2019 or later, alimony not included in income. If it was 2018 or prior, alimony is included in income. But no matter when the divorce was, child support is never included in income and it is never deductible. So, child support, never an income. Alimony, it depends on when the divorce was. For more information, you can get Publication 504.

Court Awards and Damages. Whether or not a court award is taxable depends on what it is intended for. Generally, it is not taxable if it is compensating for a physical injury or a sickness, including emotional distress due to that physical injury or illness. If it is compensation for anything else, anything other than physical injury or sickness, then it is taxable. And that includes emotional distress that is not related to the physical injury or illness. It also includes compensation for lost wages, for punitive damages, for breach of contract, etc. So, that's what you will want to remember. This is likely to be tested on the exam. If it is compensating for physical injury or sickness, not included in income. If it is compensating for anything else, it is included in income.

Gambling Winnings. This is going to be a lot like the hobby income that we talked about before. Gambling winnings must be included in income. Losses can only be deducted if you itemize deductions, and then only up to the amount of gambling income. So, again, you cannot have a gambling loss on your tax return, and you can only deduct your losses if you itemize deductions. You also include in your gambling winnings any amounts from lotteries or raffles. Non-cash items that you may win are included at their fair market value. You may receive a Form W2G. So, if you have income from a casino or a horse racing track or something like that, then you may get a W2G.

If you are a professional gambler, then you can file a Schedule C and call it a business, and you could actually have a loss from that business. However, it is not as easy as just declaring yourself a professional gambler. There was a court case that laid out all of the requirements that you have to have in order to be a professional gambler. Basically, it has to be something that you do full-time. You keep meticulous records, just like you would if it was a business. You treat it very much like a business, and that is what you do for a living. If you meet all of those requirements, then it can be a business, and you would report it on Schedule C and you could actually report a loss. But that is going to be very few people. Most of us, you are going to have to follow the other rules, include the income, and income can't take the losses unless we itemize, and you cannot show a net loss from gambling.

Scholarships and Fellowships. Scholarships and fellowships for tuition and fees are not taxable. But scholarships for room and board are taxable, and payments for services performed are taxable. So, if you're getting paid to work in the school library or the cafeteria or something like that, that is taxable. Allowances paid by the Department of Veterans Affairs are not taxable.

Now, we're going to have a list of some things that are included in income, followed by a list of things that are not included in income. So, first, the things that are included in income: Alaska Permanent Fund dividends, bribes that you receive, including in income, credit card insurance. So, sometimes if you have a credit card, you can buy insurance so that if you become unemployed or disabled, then that insurance will make those credit card payments for you. So, if you receive that benefit, those amounts are taxable to you. Fees for services that you perform, such as a corporate director or a notary public, usually you will report these on Schedule C. But if it's just for a very small amount or it's a one-time type of thing, then you would just report that as other income on your 1040. Found property is taxable to you at its fair market value. If you find $100 on the ground, that is taxable income to you. A free tour that is received for organizing a group of tourists, that is taxable income. Income from illegal activities, as we have said before, such as dealing drugs or from blackmail, anything like that, jury duty pay that you receive, that is taxable. Kickback, side commissions, and similar payments, all taxable. Prizes and awards, so if you go on Wheel of Fortune or Jeopardy or something like that, you win prizes or cash, all taxable. Rewards that you receive, maybe for turning in a criminal or returning lost property, that is taxable income. And stolen property, so if you steal something, that is taxable to you.

Not Included in Income. So, here's the list of those things: Campaign contributions that you receive, you're running for office. Carpool amounts from passengers, unless it's a business. But if you're just carpooling and everybody pitches in and gives you some gas money, you do not have to include that in income. Cash rebates from purchases, that's just considered a decrease in the purchase price of the item, it's not income. Casualty insurance and other reimbursements, so you have hail damage to your car, you get a check from the insurance company, not included in income. Child support payments, as we said, not included in income. Down payment assistance on a home, so there are some organizations that help people to buy homes, they give them a down payment, and that amount not included in income. Employment agency fees paid by an employer, so sometimes you go to an employment agency to try to find a job, and that employment agency charges you, as the one looking for the job, a fee. Sometimes the employer, when they hire you, they will pay that fee on your behalf, that is not included in your income. And any energy conservation subsidies that you may receive, not included in income. Payments received for being a foster care provider, now included. Gifts and inheritances, so this is a common question again, you'll get from clients and from people that you meet who know that you're a tax preparer. They're like, "Hey, I'm inheriting this amount. My parents died and they left me $100,000. How much tax do I have to pay on that?" And the answer is nothing. There is no income tax on a gift or an inheritance. Utility rebates that you receive, not taxable. And payments from qualified tuition programs, such as a 529 plan, as long as they are used for qualified educational expenses, are not included in income.

Net Operating Loss. So, a net operating loss is when you have losses from a business, rental property, casualty and theft, and/or deductible moving expenses that are greater than income for the year. So, usually an NOL is going to come from a business. You've got a business loss, your expenses were greater than your income. When you are computing your net operating loss, you do not include certain things. You do not include capital losses in excess of capital gains. You do not include a Section 1202 exclusion on gain, which we will learn more about in our next video. You do not include non-business deductions to the extent they exceed non-business income. You do not include any NOL carryover from a previous year. So, you don't include NOL carryover from last year in order to determine this year's net operating loss. You do not include the qualified business income deduction. And you do not include the domestic production activities deduction.

Any NOL that was generated after the year 2020 can no longer be carried back to previous years. So, it used to be if you had an NOL in one year, you could amend your previous year's tax return and use the loss for that year and actually get a refund from the previous year. But you cannot do that anymore, except for certain farmers and certain insurance companies. But anybody else cannot carry their NOLs backwards. However, you can carry your NOLs forward. So, you can use an NOL from this year to offset income in future years, but you can only offset 80% of your taxable income. So, it used to be again, you could carry an NOL forward to a future year and you could use it to offset 100% of your taxable income. Now, you can only use it to offset 80% of your taxable income. And if you still got some left, so if you don't use up all of your NOL, then you can carry forward it again to the following year, and you can keep doing that. You can keep carrying it forward to future years, and you can keep offsetting 80% of your taxable income from each of those years until the entire net operating loss is gone. You report an NOL as a negative amount in other income on Schedule One.

So, let's look at an example. In 2023, Jenny had a loss from Schedule C from operating her used clothing shop, and it resulted in a net operating loss of $40,000. In 2024, her taxable income without regard to that NOL carryforward or the QBI was $30,000. Jenny can take an NOL deduction of $24,000 in 2024. It's 80% of her $30,000 of taxable income. So, that results in her having taxable income of $6,000 for the year before taking into account the qualified business income deduction. And she has a remaining NOL carryover of $116,000. So, she started with a $40,000 NOL, she used $24,000 of it, so she has $116,000 that she can carry forward to future years. And that is the end of video two. In our next video, we will continue talking about income, specifically we will talk about capital gains. So, I will see you in video three.