Alternative Minimum Tax (A.M.T.) — A completely different system of income taxes (an alternative tax), which was cooked up in order to provide that certain folks who were able to take excellent advantage of deductions and credits offered under tax law had to pay at least a certain amount of tax (a minimum tax).
You may recall news stories some years ago about how a number of rich people paid hardly any tax at all because they were able to exploit various tax shelter programs, credits, and such. The A.M.T. was enacted to provide that they paid a certain "minimal" amount of tax.
When preparing an individual tax return, after computing the regular tax for a taxpayer, one then must compute the alternative minimum tax, and the taxpayer pays the higher of the two. Most items which are deductible or possess other tax benefits under our regular tax system are not deductible or advantaged under the A.M.T. system, so, in effect, the A.M.T. operates as a rather high-rate flat tax. Because of increases in income and deductions occurring with many middle-class taxpayers these days, more and more of them are being caught up into the Alternative Minimum Tax system. This was ostensibly never the purpose of this in the first place, as they were not the privileged rich. When doing tax planning, one has to take A.M.T. into account along with regular tax to ensure that one has a good grasp of all the issues involved.
Amortization — Essentially the same concept as depreciation, except that it is applied to intangible assets, whereas depreciation is applied to tangible assets. An intangible asset is some property acquired or owned by you or a business which has no physical existence. Examples of this would be a patent, music copyright, book rights, and so on. Amortization is usually done on a straight-line basis, meaning that the cost of the asset is written off equally over a period of years. The regulations for amortization are generally much simpler than those for depreciation.
Annuity — A series of payments made by a third party guarantor to a recipient which represents the liquidation of a sum of money. Annuities are frequently used in retirement planning and have their own special tax consequences. Annuities can also be purchased by an individual from an insurance company, separate from other tax-deductible retirement planning. Generally, an annuity amount, once the payments start, is going to be fixed, usually for a known period of time or for the lifetime of the recipient, and sometimes even for the lifetime of a recipient and a beneficiary. Income from annuities is usually reported to the taxpayer by the issuer on a special form and is, in most cases, at least partially taxable, although there are exceptions.
Appeals Officer — The Appeals Division is a separate division within the IRS to which disputes which cannot be resolved within normal IRS channels can be referred. Most commonly, tax audit issues which cannot be resolved with a tax examiner or his manager are referred to Appeals, which resolves them based on some amount of fairness as well as a calculation of the danger the case presents to the IRS. If a case cannot be resolved in Appeals, the taxpayer's only recourse is the court system. The IRS personnel who actually hear and decide appeals in the Appeals Division are called Appeals Officers,and are usually some of the more experienced employees IRS has.
At risk — This usually means what an owner has invested and/or is personally “on the hook for” as regards business debt.
Basis — Basis could be very roughly defined as “cost for tax purposes.” While cost is usually the starting point for basis, there are many ways in which basis can be changed or transferred. For example, depreciation which was taken or could have been taken on an asset in service reduces its basis. Also, if you make a gift of property, its basis in the recipient's hands will generally be the same as yours. However, assets which are inherited have a basis of (or should have a basis of ) the full market value of the asset at the time of the owner's death.
"C" corporation — A corporation organized under state law which files its own tax return, pays its own tax, and is a taxpayer in its own right. If it has profits after the payment of these taxes, it can distribute them, and these distributions are called dividends. Please note that this is a very different concept from the distribution of profits from "S" corporations.
Capital — For some accounting purposes, the capital of a business or entity is the net worth of that business or entity. It's calculated by adding up the assets of that entity or business, and then subtracting the liabilities. For business accounting purposes, the current market value of the assets and liabilities is usually not what is used to make this calculation; the adjusted acquisition value of the assets is used instead. Capital can be increased by contributions of money or assets from the owner(s) and can be decreased by distributions of profits to those owners. Capital can also be known as equity.
Capital asset — A capital asset is either an investment-type asset or an asset used in business, which, by its nature, does not get used up or consumed in some sort of process. For example, a machine which produces widgets and has an expected life span of ten years would be considered a capital asset because it required capital and was not used up or consumed in one year. Another example of capital asset would be the investment type; a share of IBM stock is a capital asset. Some sorts of capital assets can be depreciated or amortized (those types used in a business or productive activity), while investment-type capital assets cannot be.
Capital gain or loss — Profit or loss sustained from selling a capital asset.
Cash value — The nonforfeiture value (equity) inside a life insurance policy payable to the policy owner in cash.
Code — The Internal Revenue Code is the tax law of the United States. More broadly, a code is any authoritative, general, systematic, and written statement of the legal rules and principles applicable in a given legal order to one or more broad areas of life.
Community property — A special type of joint ownership recognized between married couples in nine states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. In Alaska, married couples can elect to have some or all of their property treated as community property by stating so in a written contract.
The basic idea of community property is that the marriage of two people creates a new entity, called a “community” and that all property created or acquired from that point forth will belong to that “community.” For estate tax purposes, when one owner dies, his or her 50% portion of the asset is included in the taxable estate. However, for basis purposes, the entire asset is considered to have changed hands, and the surviving spouse gets a new basis equal to the entire market value of the asset at time of the death of the first spouse.
Commuting — In tax usage, commuting is travel from your home to a place of business and back. Usually, the first trip outbound at the beginning of the day and the last trip back at the end of the day are considered commuting. If your principal place of business is an office in your home, your commute could be as short as the walk from the kitchen to your office.
Contributions and/or donations — Tax law allows for the deduction of payments made to charitable, educational, and other public-purpose-type activities that are legally recognized by the IRS. In other words, if you make payments to people for their benefit or welfare, but they are not recognized as charities or educational institutions by the IRS, the money you pay to them will not be deductible. If, however, the entity you pay the money to is a recognized charity, one may be able to claim a personal deduction for the amount of that charitable contribution.
Charitable contributions are sometimes also referred to as donations. Donations can be in the form of money or its equivalent (called "cash") or in the form of goods or property. For example, I can donate furniture to the local Goodwill, or I could give them a check. The law and regulations governing cash and noncash donations are somewhat different. Generally, donations are only deductible if they are of your free will and no return benefit of any sort is received by you. One exception to this is donations for which the only return benefit received is an intangible religious service. Whenever some sort of benefit is received by a donor in exchange for his donation, the charity which receives the money must issue paperwork detailing the value of the goods or services received by the donor, and the donor is only allowed to write off those contributions which exceed the value of the items he receives in return (unless the items received in return are purely intangible religious services, as mentioned above).
Controlled group — Basically, two or more “C” corporations substantially owned or controlled by the same interests. When this occurs, the entire group of corporations is treated as being one corporation for purposes of using tax brackets and computing tax rates.
Cost of goods sold or operations — The cost of actually acquiring or producing the items which were sold, if your business sells items, or the "hard" or directly-related costs of providing services, if you're in a service business. For Widgets, Inc., a manufacturer, the cost of producing widgets which were actually sold are the costs of goods sold. So, if one sold 500 widgets but produced 1,000, one would only be able to consider as one's cost of goods sold the cost of producing 500 of them. For a consulting business, the direct cost of delivering services called for by contracts would be the cost of operations.
Furthermore, tax law requires that all ancillary costs connected to the production or sale of goods which were then sold must be included in this computation. So, if one rents a factory to produce the widgets, the rent of the factory would be included in the cost of goods sold calculation, as would the utilities, the factory labor, and all other related expenses. Once again, it’s important to recognize that the cost of producing 1,000 widgets is not deductible in entirety if one only sells 500 of them. In this example, the business owner would effectively only be allowed to deduct half his rent, utilities, factory labor, and related expenses.
Credit — A credit is a direct dollar-for-dollar reduction against tax authorized by law. One example of this is foreign tax credit. In this case, one can reduce the amount of tax paid to the United States on a dollar-for-dollar basis for the amount of tax paid on the same income to a different country. Credits are considered much more valuable than deductions or adjustments or exemptions since they do not reduce taxable income but actually reduce the tax itself.
Deductible — In insurance policies, the amount of a claim that the insurance company won't pay and which is the responsibility of the policy holder.
Deduction — A type of outflow (as defined below) which is allowed on a tax return, which can then reduce the taxable income of an individual, a business, or operating activity. For example, if I have a property I'm renting and pay utility bills for that property, these bills are a deduction. If I’m running a business and spend money for employee’s wages, those wages are a deduction. A deduction can also include an amount which can be taken out of (or deducted) from an income sum which relates to the acquisition of an asset. Generally, when assets are acquired, one is allowed to depreciate or amortize (see below and above) these assets, and the amount of depreciation or amortization allowable for the year in question is a deduction.
Dependent — A person for whom one is allowed to claim an exemption amount on one's personal tax return because one supports that person. The classic example of a dependent is a child who lives with you and whom you support. Dependents can also be other family members who live with you (or perhaps don’t), or other non-family members who do live with you. There is an extensive set of rules which govern whether someone can be claimed as a dependent. Once again, the value of claiming a dependent is the fact that one is able to exempt a certain amount of money from tax as a result of claiming that dependent. Having said this, it should be noted that the exemption amounts for dependents phase out for higher income taxpayers and eventually reach zero. Dependents are also not allowed under the Alternative Minimum Tax system.
Depreciation — A concept which recognizes that some things a business purchases might last for more than one year and that some sort of deduction should be allowed for this item as it is getting used up. The life span of depreciable assets and all the other characteristics and requirements of depreciation are very tightly regulated by tax law.
Let's say that I bought a new computer for use in my business and the computer cost $2,000. Since the computer is an asset which will last more than one year, I’m required to depreciate it, rather than claiming the entire $2,000 as a deduction this year. Current federal tax law allows me to depreciate the cost of that computer over a five-year period. So,for example, I might be able to write off $400 as a deduction in the year I acquire the computer, and $400 in each of the subsequent four years, until I've written off the entire $2,000 acquisition cost.
The concept of depreciation is based on the idea that one needs to set aside a certain amount of the cost of an asset each year to assemble the cost of its replacement. Using the computer as an example, let’s say that I think the computer will have a service life of five years, so I set aside $400 per year in order that, at the end of the five-year period, I have $2,000 in the bank with which to purchase a new computer. Special provisions in tax law allow for acceleration of depreciation and for a complete write-off of acquisition costs for certain types and amounts of depreciable assets.
For example, I could acquire that computer this year for $2,000 and elect to deduct the entire $2,000 this year. This can only be done by making an affirmative election to do so, and only can be done in certain circumstances. As an interesting sidelight, the amount of cash actually paid for the acquisition of a depreciable asset can vary enormously from the amount which is deductible in any one year. Let's say I buy the same $2,000 computer but pay nothing this year, and instead agree to 36 easy monthly payments, to start after January 1. I can still write off $400 as my depreciation for this year, even though I’ve paid no actual cash for the asset in this year.
Dividend — A dividend is a distribution of profits from a corporation which is not taxed as an "S" corporation. Corporations which are not taxed as "S" corporations are generally called "C" corporations.
Election — There are many issues in tax law where a taxpayer can elect to have an item treated one way or another. For example, a taxpayer can elect to claim the entire acquisition cost of a depreciable asset all in the year of acquisition, as long as certain requirements are met. If the taxpayer does not make that election, the asset is required to be depreciated normally, and its cost recovered over a period of years. There are many, many elections in tax law, and one has to be alert to these in order to make the proper ones. Many elections must be made by some sort of statement or a written indication on a tax form that an election is being made, although that is not always the case.
Equity — see Capital and Cash value
Estate tax — A tax on the transfer of the value of assets from a decedent to heirs. The tax is computed on the total value of all the decedent's assets at the time of death plus lifetime gifts, less deductions for items like debts, charitable donations made by the estate, and final expenses. See also gift tax.
Estimated tax — The American income tax system is a “pay as you go” system. This means that the government wants you to make payments of the tax on a periodic basis to them, rather than leaving it all ‘till the end of the year and paying it in one big chunk. This is enforced by both withholding from wager-earner salaries and by requiring people who do not have any (or enough) withholding coming from their income to make payments of estimated tax. These payments are made quarterly and are based on an estimate of what you think you'll owe for that year. If one fails to make estimated tax payments on time or of a sufficient amount, one can be penalized.
Exclusion — An exclusion is simply some amount which is excluded from a computation. There are different sorts of exclusions in tax law, which are subject to change, and each one is separate and special within its own field.
Exemption — In tax law, an exemption is an amount that is exempt from tax. There's a amount which is exempt from taxes for each person who appears on a personal income tax return. Persons who can appear are the taxpayer, his spouse, his children, his dependents, and so on, and this amount generally changes each year. As an example, let's say that the exemption amount for the current year is $2,000. This means that a married couple with no children or other dependents filing an income tax return can claim $4,000 as being exempt from tax.
Expense — As a generality, an expense is any sort of outflow of money or exchangeable product which is surrendered or given up in order to secure some sort of benefit or good or service relevant to an ongoing activity. For example, if I have a small business and I pay rent, the rent is an expense. This term doesn't cover any funds expended for the acquisition of an asset. It also does not cover any funds which are advanced on behalf of another for which one expects reimbursement.
Extension — All tax returns have due dates; the exact due date for a tax return varies by type. However, in most cases, one is allowed to extend a tax return beyond its due date. For federal tax purposes, various forms are used to accomplish these extensions. Some may be sent in without signature, whereas some require it. In all cases, the tax due as of the filing due-date or a reasonable estimate of it must be stated on the extension form in order for the extension to be completely valid. If the estimate of tax due shown is not reasonable, the IRS can consider the extension invalid. In some cases, multiple extensions can be gotten for certain types of tax returns, but nowadays only one extension period is available for most returns. For California state tax purposes, extensions are also available, but for the most part these extensions are paperless, meaning that if you don’t send them the money you may not have an extension. The only real extension is your canceled check.
Fiscal Year — Any yearly period without regard to the calendar year, at the end of which a firm, government, and the like, determines its financial condition. In tax usage, a fiscal year is usually different from a calendar year, which is an accounting year, as you might guess, starting on January 1st and ending on December 31st. Almost all fiscal years end on the last day of some month and are 12 months long. As an example, a tax or accounting year which begins on May 1st and ends on April 30th of the following year would be a fiscal year.
Fringe benefit — A payment or benefit provided to a worker in addition to salary or wages. It may take the form of cash, goods, or services, and may include such items as health insurance, pension plans, and paid vacations. Different benefits are subject to different tax treatments.
Gift tax — In our current tax system, all transfers from one party to another are subject to some sort of tax. Transfers in payment for goods or services are subject to income tax; transfers made freely in good will with no intent to exchange for goods and services are subject to gift tax; and transfers at death are subject to estate tax. Income taxes are paid by the recipient of those transfers, while estate and gift taxes are paid by the transferor. Estate and gift taxes were unified some years ago, and (assuming the restoration of estate taxation) share a common lifetime exemption amount. Transfers which exceed the exemption amount were and will be (given that restoration) subject to tax. If the exemption amount is exceeded in one's lifetime with gifts alone, a gift tax was and will be due, and one's full estate would be subject to estate tax. If the exemption is only exceeded when adding lifetime gifts to one's estate, then only estate tax was and will be due.
Gross income — The total income from all sources for that particular taxpaying entity. For individuals, it's defined under adjusted gross income. For businesses or rental activities, it's the total income from all sources coming into the business before any deductions are computed.
Gross profit — Most applicable to an operating business and is defined as the gross income from that business minus the cost of the goods sold in the business or minus the hard costs of operating that business. For example, if you're in the business of making and selling widgets, your gross profit is your gross income minus the cost of producing the widgets which were actually sold (any unsold become inventory).
As another example, if you're a consulting firm which hired outside contractors to fulfill its consulting contracts, the gross profit might be the total income received from all sources less the amount you paid to your outside consultants in order to actually deliver the services for which you were paid.
Group plans — Insurance policies can be issued to individuals or groups. The term “group plan” usually applies to either group health or group life insurance. Individual policies generally evaluate the risk of insuring a particular individual, and they charge for or restrict coverage according to what they consider that risk to be. Group plans usually do not evaluate the risk of insuring each individual in a group but instead evaluate the risk of insuring the group overall. Group plan premiums are usually cheaper per person than individual policies because of lower administrative and other costs.
Income — In tax law, income is an inflow of some sort of exchange for services rendered, goods provided, or assets exchanged. Income is taxable by default, unless it is specifically exempted from tax under the Internal Revenue Code. For example, wages you earn from a job are income. So are consultant fees that you might earn as a self-employed consultant, or the profit you might make from disposing of a house.
Inflow — Usually used to refer to any sort of financial benefit that a person or company might receive. For example, your aunt could reimburse you for some expenses you paid out of pocket and that would be an inflow to you. However, it is not income since it’s only just a reimbursement for money you already paid out of pocket.
Intangible asset — Property acquired or owned which has no physical reality. Examples of this would be a patent, a copyright, book rights, or a piece of music.
Interest — Money paid by one party to another for the "rental value" of money. If I lend you money, since you have it and I no longer do, I’m going to charge you rent for that money for the period of time you have it. This rent is the interest. Under tax law, interest is a mandatory characteristic of all genuine loans. If the loan itself does not bear interest, tax law presumes that it does, and assigns a minimum rate of interest which must be charged (and can then be taxed). Interest income is always taxable to the recipient and sometimes deductible to the payer.
Inventory — The property that a manufacturing and/or selling business keeps on hand with which to manufacture or sell. For example, a widget manufacturer keeps batches of raw material around the factory for making widgets; these are part of its inventory. Additionally, the completed, unshipped widgets are part of its inventory. In a sales business, the items kept on the shelves in order to sell to customers are the inventory. Keeping track of inventory is very important for tax purposes.
Investment — An investment is some sort of property purchased for, and with the primary purpose ofproducing, income. The income produced by investment property will generally be interest, dividends, or capital gains. Personal-use property, such as one's home, is not investment property for tax purposes.
Investment income — Commonly interest, dividends, or capital gains produced by investment holdings. This concept is significant because deductions against investment income must be written off in a particular way, and interest expended on loans used to secure investment assets is limited in terms of its deductibility. Generally, interest on investment-related loans is deductible only to the degree that one has investment income. Currently, both capital gain income and qualified dividend income are taxed at a maximum federal tax rate of 15%, although that may change soon. Any capital gains or dividend income which are taxed at this 15% rate are not considered investment income for purposes of determining the deductibility of investment-related interest. One can elect to have this income taxed at the higher rate of ordinary income, which then makes it investment income for purposes of determining an investment interest deduction.
IRA/Roth IRA — IRA stands for Individual Retirement Account and is sometimes pronounced as one word, like the name "Ira." It’s important to remember that this account is held by an individual and not a married couple or any other more-than-one-person arrangement. An IRA is an account into which a person can contribute money for future income purposes. Once the money is in the IRA account, any investment earnings occurring will not be taxed annually. Regular IRAs are taxed differently from Roth IRAs. In a regular IRA, the money contributed to the account is usually deductible at the time of the contribution, and the distributions from the account, when made, are generally taxable.
In the case of a Roth IRA, the contributions to the account are generally not deductible at the time of the contribution, but on the other hand, the distributions are usually not taxable when they come out later. Only some taxpayers qualify for an IRA or a Roth IRA, because of their earned income, their total income, or other factors. In many cases, if a taxpayer qualifies for a Roth IRA, this generally will work out to be a more suitable arrangement for him or her in the long term than will a regular IRA.
IRC — see "Code"
Itemized deductions — Personal deductions from income which are allowable based on the actual expenses of the taxpayer. General categories of itemized deductions are medical and dental expenses, state and local taxes, mortgage and investment interest, charitable donations, casualty and theft losses, and other miscellaneous items related to the production or protection of income.
Joint ownership — Usually means joint tenants with rights of survivorship, frequently abbreviated on account statements as "JTWROS.” This means that, essentially, all owners own the entire asset. Therefore, if there are two or more owners on the asset and one owner dies, then the surviving owner or owners will continue to own the asset and the estate and legal heirs of the deceased owner will receive nothing. For estate tax purposes, the deceased owner's portion is considered to have passed through his or her estate and is subject to estate taxation even if the estate and legal heirs receive nothing, since all this means is that an asset jointly owned passes directly to the joint owner(s), bypassing the distribution rules of the estate. The basis of the portion of the asset in the hands of the remaining owner(s) which was subjected to estate tax would be the value of the asset on the date of death of the deceased owner.
“Kiddie” tax — Applies to any child until they turn 19 (or 24 if they're dependent full-time students), and the intent is to subject any unearned income the child may have above a certain ceiling to the same tax rate as the parents.
Living trust — A trust created during a person's lifetime, usually designed to avoid probate proceedings, and which can, in addition, be used to reduce taxes (on a limited basis), to safeguard financial privacy, to regulate the use of assets if the owner becomes incapacitated, and for other purposes.
LLC (limited liability company) — Now legal in all 50 states, an LLC is an unincorporated company which provides limited liability to its members for the liabilities of the company. Previously, only corporations provided this sort of limited liability.
Long-term care insurance — An insurance policy to cover (some of ) the costs of a covered person who ends up in a long-term care facility (also called a nursing home).
Loophole — A provision in the tax code, possibly unintentional, which provides a tax break, and which may be inconsistent with other, similar provisions. Also, a means or opportunity of evading a rule, law, and so forth.
Loss — A loss is usually declared when an operating entity spent more than it made for a particular period of time or activity, or where an asset is sold for less than it cost. Losses can frequently be used to offset income from other areas, although there's a complex web of regulations surrounding exactly which gains can be reduced by losses and under what circumstances.
Medical expenses — Tax law allows individual taxpayers to deduct expenses paid for the maintenance or repair of their health, generally called medical expenses. This whole area is somewhat vague and possibly confusing as to what sort of expenses are deductible. As examples, drugs are fully deductible, whereas dietary supplements are generally not deductible unless provided by or purchased from a health care professional at the time of a health care service. Medical expenses can include items as varied as travel to a remote hospital for medical care, lodging and meal expenses while at that remote location, changes to one's home in order to accommodate a medical need, and other related items. The standard, commonly, is that there is some genuine medical need to which a health care professional will either attest or for which he will provide a written prescription. Usually, treatment illegal within the United States is not deductible.
Mortgage — A loan secured by a piece of real property.
MSA/HSA — Currently, there are two types of savings plans tailored for medical expenses. One is an MSA (Medical Savings Account) and the other is an HSA (Health Savings Account). The Health Savings Account is the more recent development, and MSA plans no longer can be set up, although existing accounts can be used freely. MSA plans are recognized by the State of California, whereas HSA plans are not.
The general idea of both these plans is that an individual taxpayer must have a special type of high deductible health insurance plan in effect, and then he's allowed to contribute a percentage of his annual deductible under this plan or some other determined amount to the savings account. The amount he contributes to the savings account can be taken as an adjustment on his personal income tax return, and any withdrawals made from these accounts are not taxable as long as they remain less than his allowable medical expenses for the year in question. These sorts of accounts were originally established to provide Americans more flexibility and responsibility regarding their own health care.
I personally find these plans an excellent alternative to other health care arrangements in that they tend to reward people who don’t get sick, because the insurance coupled to such plans is usually relatively inexpensive, and you get to keep the money inside the savings plan if you don’t burn it up on medical expenses.
© 2010. William D. Truax, E. A., Inc. All Rights Reserved
To find out more about William D. Truax, E.A., Inc., visit their web site at www.truax.net
Comments, and opinions in this glossary convey the views of William D. Truax, E. A. Inc. on topics they believe are of interest to their clients and the general public.They are not intended as legal, tax, or investment advice.
If and only to the extent that this publication contains contributions from tax professionals who are subject to the rules of professional conduct set forth in Circular 230, as promulgated by the United States Department of the Treasury, the publisher, on behalf of those contributors, hereby states that any U.S. federal tax advice that is contained in such contributions was not intended was not intended or written to be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer by the Internal Revenue Service, and it cannot be used by any taxpayer for such purpose.