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Glossary of Tax Terms

Want to hear a foreign language? Go to a tax office during tax season! Below is a list of common tax terms and their meanings, in plain English.

401(k) Plan

A section 401(k) plan is a type of tax-qualified deferred compensation plan in which an employee can elect to have the employer contribute a portion of his or her cash wages to the plan on a pre–tax basis. These deferred wages (commonly referred to as elective deferrals) are not subject to income tax withholding at the time of deferral, and they are not reflected on the employee’s Form 1040 since they were not included in the taxable wages on the Form W-2. However, they are included as wages subject to Social Security, Medicare, and federal unemployment taxes. Distributions from a 401(k) plan may qualify for optional lump–sum distribution treatment or rollover treatment as long as they meet the respective requirements. Many 401(k) plans allow employees to make a hardship withdrawal because of immediate and heavy financial needs. Generally, hardship distributions from a 401(k) plan are limited to the amount of the employee's elective deferrals only, and do not include any income earned on the deferred amounts. Hardship distributions are not treated as eligible rollover distributions. Distributions received before age 59 1/2 are subject to an early distribution penalty of 10% additional tax unless an exception applies.

Accelerated Cost Recovery System (ACRS)

ACRS is not used much anymore as it was phased out after 1986. ACRS was an accelerated form of depreciation. The class lives were shorter. The cost was recovered much sooner than Congress intended, and in 1986, Congress gave us a combination of an older system, CLADR, and ACRS to arrive at what we currently use – MACRS.

If you are interested in learning more, come into our office, take one of our tax courses, or refer to Publication 534.

Accounting Method

Each taxpayer must use a consistent accounting method, which is a set of rules for determining when to report income and expenses. The most commonly used accounting methods are the cash method and accrual method. The following is a brief description of each:

Cash Method – Only income actually or constructively received during the year is reported. (Income is constructively received when it is credited to the taxpayer’s account or set aside for the taxpayer’s use.) Expenses are reported in the year paid.
Accrual Method – Report income when it is earned and deduct expenses when they are incurred even if they are not paid during the tax year. If a taxpayer has inventory they are no longer required to use the Accrual Method by the IRS if their gross receipts are under $1 million dollars.

Accounting Period

Accounting Period is another way of saying Tax Year. As an individual or business, you choose your tax year for keeping records and reporting income and expenses. You can use either of the following tax years as your accounting period:

A Calendar Year (usually from January 1 through December 31)
A Fiscal Year (including a 52-53-week tax year, which can begin on any date during the calendar year). Generally, individuals use a calendar year for record keeping and reporting taxes, while businesses may use the fiscal year.

Accrual Method

Report income when it is earned and deduct expenses when they are incurred even if they are not paid during the tax year. If a taxpayer has inventory they are required to use the Accrual Method, unless their gross receipts are under $1 million.

Acquisition Debt

Home acquisition debt is a mortgage you took out after October 13, 1987, to buy, build, or substantially improve a qualified home (your main or second home). It also must be secured by that home.

Additional Child Tax Credit

This credit is for certain individuals who get less than the full amount of the Child Tax Credit. The additional child tax credit may give you a refund even if you do not owe any tax.

Adjusted Basis

Adjusted basis is merely the cost or other original basis assigned to the property when it was acquired, increased and/or decreased by other items.

Items that increase basis are:

Cost of improvements (for example, the addition of a room to a house).
Assessments for local improvements (sewers, for example) and the cost of extending utility service lines to the property.
Legal fees, including those for defending a title or obtaining a decrease in an assessment levied for local improvements.

Items that decrease basis are:

Amortization, depreciation and depletion allowed or allowable. (If the taxpayer does not take depreciation, the basis is still decreased since the depreciation was allowable.)
Section 179-expense deduction.
Tax free dividends (returns of capital).
Casualty losses deducted on a return.
Insurance reimbursement for property damage.
Deferred gains (for example, gain from the sale of a residence).
Discounts and rebates off the purchase price (for example, rebates by auto manufacturers).

Adjusted Gross Income (AGI)

AGI is gross income (anything reported in the INCOME section of Form 1040) minus any adjustments to income.

Adjustment to Income

The IRS allows some deductions to your gross income, resulting in Adjusted Gross Income (AGI). Several examples of adjustments to income that you can deduct are: Educator Expenses , Student Loan Interest, IRA Deduction, Alimony Paid, Self-Employed Health Insurance, Health Savings Account Contributions and half of Self-Employment Tax.

Alimony

Alimony is a maintenance payment from one former spouse to another usually granted under a separation agreement or decree of divorce. Payments received are taxable in the year you received them and reported on Form 1040. Payments made may be deductible. Additional information can be found in Tax Topic 452, Alimony Paid; and Publication 504, Divorced or Separated Individuals.

Alternative Minimum Tax (AMT)

The AMT came into being with the Tax Reform Act of 1969. Its purpose was to target a small number of high-income taxpayers who could claim so many deductions they owed little or no income tax. A growing number of middle-income taxpayers are discovering they are subject to the AMT. In 2007, Congress initiated changes to the AMT to ease this burden on middle-income taxpayers.

Amended Return

The taxpayer will file a Form 1040X to correct their Form 1040. The correction could produce a refund or it could result in an amount due. The taxpayer may also file an amended return to change their filing status from married filing separately to married filing jointly. The taxpayer cannot change from married filing jointly to married filing separately after the due date of the tax return. When a taxpayer prepares a Form 1040X they must use the tax law, rules, rates, and schedules applicable to the year being amended. These change every year, so it is important for the taxpayer to use the correct rates. The taxpayer must attach all the appropriate forms and schedules to Form 1040X. Generally, the taxpayer should file Form 1040X within 3 years after the date they filed their original return or within 2 years after the date they paid the tax, whichever is later. A return filed early is considered filed on the due date.

Amortization

Amortization is basically the same thing as depreciation. Depreciation deals with tangible property (car, furniture, tools, etc.) and amortization deals with intangibles (goodwill, costs of starting a business, etc.).

Annuity

An annuity is a series of regular payments that will continue for a fixed period of time or until the death of the recipient. Whether or not the distribution to the employee is taxed depends on whether the employee made contributions to the plan. When an employee puts money into a retirement account, it is called a contribution. When an employee takes money out of a retirement account it is called a distribution. The employee will need to compute the portion of distributions that are tax-free. If the taxpayer never put a dime into the company pension fund, all distributions will be taxable. This is an employer-funded plan. If the taxpayer contributed to their company pension fund,a portion of the distribution they receive will be a tax-free recovery of contributions.

Audit

An audit is an examination of your federal income tax return by the IRS to determine whether income, credits and expenses have been reported accurately.

Basis

There are two types of basis:

Cost Basis – The basis of purchased property is usually its cost. The cost may be paid for in cash, debt obligations such as mortgages, or in other property.
Adjusted Basis – Adjusted basis is merely the cost or other original basis assigned to the property when it was acquired, increased and/or decreased by other items.

Blind

You qualify for a higher standard deduction if you are totally or partially blind, if you do not itemize your taxes.

Partly blind - You are considered partly blind if you have a certified statement from your eye doctor or registered optometrist that:

Your vision is not better than 20/200 in the better eye with glasses or contact lenses, or
Your field of vision is not more than 20 degrees.

Business Expenses

Business expenses are the cost of carrying on a trade or business. These expenses are usually deductible if the business is operated to make a profit.

Capital Gain/Loss

Gain or loss from the sale or exchange of a capital asset is the difference between the gross sales price and the adjusted basis plus any expenses of the sale. If the gross sales price is more than the adjusted basis plus any expenses of the sale, the result is a gain. If adjusted basis plus any expenses of the sale is more than gross sales price, the result is a loss. Gains realized on the sales or exchanges of personal-use, investment-use, and business-use assets are taxable. Losses on the sale or exchange of investment-use and business-use assets are deductible. Losses on the sale or exchange of personal-use assets are not deductible. Gains or Losses from the sale of a Capital Asset are considered Capital Gains or Capital Losses.

Cash Method

Only income actually or constructively received during the year is reported. (Income is constructively received when it is credited to the taxpayer’s account or set aside for the taxpayer’s use.) Expenses are reported in the year paid.

Charitable Contribution

You may deduct charitable contributions of money or property made to qualified organizations if you itemize your deductions. Generally, you may deduct up to 50% of your adjusted gross income, but 20% and 30% limitations apply in some cases.

Child and Dependent Care Credit

If you paid someone to care for a qualifying individual so you (and your spouse if you are married) could work or look for work, you may be able to claim the credit for child and dependent care expenses. If you are married, both you and your spouse must have earned income, unless one spouse was either a full–time student or was physically or mentally incapable of self–care.

Child Support

Child support is generally granted in a separation agreement or divorce decree and cannot be claimed as either income or as a deduction on income taxes.

Child Tax Credit

This credit is for people who have a qualifying child as defined below. The maximum amount you can claim for the credit is $1,000 for each qualifying child.

Qualifying Child

A qualifying child for purposes of the child tax credit is a child who:

Is your son, daughter, stepchild, foster child, brother, sister, stepbrother, stepsister, or a descendant of any of them;
Was under age 17 at the end of the tax year;
Did not provide over half of his or her own support for the tax year;
Lived with you for more than half of the tax year; and
Was a U.S. citizen, a U.S. national, or a resident of the United States.

Combat Pay

You can elect to include your nontaxable combat pay in earned income for the earned income credit. If you make the election, you must include in earned income all nontaxable combat pay you received. If you are filing a joint return and both you and your spouse received nontaxable combat pay, you can each make your own election. The amount of your nontaxable combat pay should be shown on your Form W-2 in box 12 with code Q. If you serve in a combat zone as an enlisted person or as a warrant officer (including commissioned warrant officers) for any part of a month, all your military pay received for military service that month is excluded from gross income. For commissioned officers, the monthly exclusion is capped at the highest enlisted pay, plus any hostile fire or imminent danger pay received.

Combat Zone

Combat zones are designated by an Executive Order from the President as areas in which the U.S. Armed Forces are engaging or have engaged in combat.

Community Property

Community property is property:

That you, your spouse, or both acquire during your marriage while you are domiciled in a community property state. (Includes the part of property bought with community property funds if part was bought with community funds and part with separate funds.)
That you and your spouse agreed to convert from separate to community property.
That cannot be identified as separate property.

Coverdell Education Savings Account (ESA)

A Coverdell ESA is a trust or custodial account set up in the United States solely for the purpose of paying qualified education expenses for the designated beneficiary of the account. In general, the designated beneficiary of a Coverdell ESA can receive tax-free distributions to pay qualified education expenses. The distributions are tax-free to the extent that the amount of the distributions does not exceed the beneficiary's qualified education expenses. If a distribution does exceed the beneficiary's qualified education expenses, a portion of the distribution is taxable.

Custodial Parent

The custodial parent is the parent with whom the child lived for the greater part of the year. The custodial parent is usually allowed to claim the exemption for the child if the other exemption tests are met.

Defined Benefit Plan

A defined benefit plan is any plan that is not a defined contribution plan. Contributions to a defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Actuarial assumptions and computations are required to figure these contributions. Generally, you will need continuing professional help to have a defined benefit plan.

Defined Contribution Plan

A defined contribution plan provides an individual account for each participant in the plan. It provides benefits to a participant largely based on the amount contributed to that participant's account. Benefits are also affected by any income, expenses, gains, losses, and forfeitures of other accounts that may be allocated to an account. A defined contribution plan can be either a profit-sharing plan or a money purchase pension plan.

Dependent

Generally, you may claim a dependency exemption for a qualifying child or a qualifying relative. You may not claim a dependency exemption for an individual, however, if you are a dependent of another taxpayer. Refer to Publication 501, Exemptions, Standard Deduction and Filing Information, for the definitions of a qualifying child and a qualifying relative.

Depreciation

Depreciation is the annual deduction allowed to recover the cost or other basis of business or investment property having a useful life beyond the tax year. Land is never depreciable. Depreciation starts when the taxpayer first uses the property in their business for the production of income. This might not be the same year it was purchased.

Earned Income

Pay you received for work actually done – salary, tips, etc. If you are a dependent on someone else’s return, earned income would also include any part of a scholarship or fellowship grant that the dependent must include in his or her gross income.

Earned Income Credit (EIC)

Earned Income Tax Credit – A tax credit for eligible people who work and have income less than specified amounts. The amount of the credit is based on income, filing status and number of qualifying children, if any. If the EIC exceeds the amount of taxes owed, the client receives a tax refund if they’ve claimed and qualify for the credit.

Educator Expenses

If you are an eligible educator, you can deduct up to $250 of your unreimbursed expenses [otherwise deductible trade or business expenses] you paid or incurred for books, supplies, computer equipment (including related software and services), other equipment, and supplementary materials that you use in the classroom. You can deduct these expenses even if you do not itemize deductions on Form 1040, Schedule A. This deduction is for expenses paid or incurred during the tax year.

Entertainment Expenses

Entertainment expenses that are both ordinary and necessary in carrying on a trade or business may be deductible if they meet one of the following two tests:

Directly–Related test - To meet the directly-related test for entertainment expenses (including entertainment-related meals), you must show that:

The main purpose of the combined business and entertainment was the active conduct of business,
You did engage in business with the person during the entertainment period, and
You had more than a general expectation of getting income or some other specific business benefit at some future time.

Associated Test - To meet the associated test for entertainment expenses (including entertainment-related meals), you must show that the entertainment is:

Associated with the active conduct of your trade or business, and
Directly before or after a substantial business discussion.

Estate Tax

The estate tax is a tax on your right to transfer property at your death. It consists of an accounting of everything you own or have certain interests in at the date of death.

Estimated Tax

Some types of income may not be subject to withholding. This includes income from self-employment, interest, dividends, alimony, rent, gains from the sale of assets, prizes, and awards. The taxpayer may also have to pay estimated taxes if their withholding is not sufficient to cover their tax liability.

Estimated tax is used to pay income tax and self-employment tax, as well as other taxes and amounts reported on the tax return. If the taxpayer does not pay enough through withholding or by making estimated tax payments, they may be charged a penalty. If the taxpayer does not pay enough by the due date for each payment period, they may be charged a penalty even if they are due a refund when they file their return.

Exemption

You are allowed one exemption for each person you can claim as a dependent. You can claim an exemption for a dependent even if your dependent files a return.

Fair Market Value (FMV)

FMV is the price at which property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the necessary facts. Sales of similar property on or about the same date may be helpful in figuring the FMV of the property.

Foreign Tax Credit or Deduction

Taxpayers can claim a foreign tax credit for most taxes paid to a foreign government on income that is also subject to U.S. Federal Income Tax. The credit was designed to ease this double taxation on the same income. Typically, when a foreign tax credit is claimed the taxpayer needs to complete and attach Form 1116. If the foreign tax is less than $300 ($600 for married filing jointly) and is from passive income, then the taxpayer may be able to enter the foreign tax directly on Form 1040 and avoid filing Form 1116.

Form 1040X

Use Form 1040X, Amended U.S. Individual Income Tax Return, to correct a previously filed Form 1040, Form 1040A, Form 1040EZ, or TeleFile return. To avoid penalty and interest, if you owe additional tax for 2008, you should file Form 1040X and pay the tax by April 15, 2009.

Gift Tax

If you give someone money or property during your life, you may be subject to federal gift tax.

Gross Income

Gross income is all income from all sources (other than tax-exempt income) that must be included on your tax return.

Head of Household

Generally, you may claim head of household filing status on your tax return only if you are unmarried and pay more than 50% of the costs of keeping up a home for yourself and your dependent(s) or other qualifying individuals.

Health Savings Account (HSA)

An HSA is a tax-exempt account set up with a qualified trustee to reimburse you for certain medical expenses. You must be an eligible individual to qualify for an HSA. You do not need permission or authorization from the IRS to establish an HSA. A qualified HSA trustee can be a bank, an insurance company, or anyone approved by the IRS to be a trustee of IRAs or Archer MSAs. The HSA does not need to be set up with your health plan provider.

The benefits of an HSA include:

Contributions you, or someone other than your employer, make to your HSA are deductible, even if you don’t file Schedule A.
Contributions to your HSA made by your employer (including those made through a cafeteria plan) may be excluded from your gross income.
The contributions stay in your account until you use them.
The interest earned on the account is tax-free.
Distributions may be tax-free if you pay qualified medical expenses.
An HSA is independent of your employer, so it stays with you if you change jobs, or stop working.

Eligible individuals:

Must have a high deductible health plan (HDHP), on the first day of the month in which you start the HSA.
Must not have any other health coverage, with a few exceptions.
Cannot be enrolled in Medicare.
Cannot be claimed as a dependent on someone else's tax return.

Hobby

Hobbies, also called not-for-profit activities, are those activities that are not pursued for profit. What is a business? Generally, your activity is considered a business if it is carried on with the reasonable expectation of earning a profit.

Hope Credit

A taxpayer may claim a credit of up to $1,650 for qualified expenses paid for each student who qualifies for the Hope Credit. A taxpayer is allowed 100% of the first $1,100 of higher education expenses and 50% of the next $1,100 for a maximum of $1,650.

Innocent Spouse

By requesting innocent spouse relief, you can be relieved of responsibility for paying tax, interest, and penalties if your spouse (or former spouse) improperly reported items or omitted items on your tax return. Generally, the tax, interest, and penalties that qualify for relief can only be collected from your spouse (or former spouse). However, you are jointly and individually responsible for any tax, interest, and penalties that do not qualify for relief. The IRS can collect these amounts from either you or your spouse (or former spouse).

Itemized Deductions

You may benefit from itemizing your deductions on Schedule A (Form 1040) if you:

Do not qualify for the standard deduction, or the amount you can claim is limited,
Had large uninsured medical and dental expenses during the year,
Paid interest and taxes on your home,
Had large unreimbursed employee business expenses or other miscellaneous deductions,
Had large uninsured casualty or theft losses,
Made large contributions to qualified charities, or
Have total itemized deductions that are more than the standard deduction to which you otherwise are entitled.

Lifetime Learning Credit

The maximum Lifetime Learning Credit is $2,000 per family per year, regardless of the number of students. The Lifetime Learning Credit is 20% of the first $10,000 of qualified expenses paid for all eligible students.

Modified Accelerated Cost Recovery System (MACRS)

Property placed in service after December 31, 1986 – MACRS is typically used 95% of the time when depreciating assets. MACRS is almost the same as ACRS except the class lives have been extended and depreciation methods are more rapidly accelerated.

Qualified Dividend

A qualified dividend is eligible for a lower tax rate and should be reported in Box 1b of Form 1099-DIV. The lower tax is figured on the Qualified Dividends and Capital Gain tax worksheet or the Schedule D tax worksheet.

Qualifying Widow(er) with Dependent Child

In the event that a spouse dies, the taxpayer may file married filing jointly in the year of death. For the two years following the year the spouse died, they may file as Qualifying Widow(er) if they meet the following requirements:

They were entitled to file a joint return with their spouse the year the spouse died.
The taxpayer did not remarry before the end of the tax year for which the return is being filed.
The taxpayer has a child or stepchild for whom they can claim an exemption. This does NOT include a foster child.
The taxpayer paid more than half the cost of keeping up a home that was the main home for the taxpayer and the child for the entire year.

This filing status allows the taxpayer to use joint return tax rates and the highest standard deduction amount.

Rental Income

Generally, cash or the fair market value of property you receive for the use of real estate or personal property is taxable to you as rental income. You can generally deduct expenses of renting property from your rental income.

Section 179 Expense Deduction

Capital expenditures (assets having a life longer than a year) must be depreciated over their respective class life. Congress allows a taxpayer to expense a significant amount in the current year under Section 179 of the Internal Revenue Code, if all requirements are met.

Self-Employment Tax

If a taxpayer carries on a trade or business and the business has net earnings from self employment equal to or greater than $400, the taxpayer will need to file Schedule SE with their tax return. Schedule SE is used to compute the self-employment tax due on the net self-employment income from Schedule C or F. This tax is in addition to the regular tax on earnings.

Simplified Employee Pension (SEP)

A SEP is a simplified employee pension plan. A SEP plan provides employers with a simplified method to make contributions toward their employees’ retirement and, if self-employed, their own retirement. Contributions are made directly to an Individual Retirement Account or Annuity (IRA) set up for each employee (a SEP-IRA).

Social Security Tax

If you work as an employee in the United States, you must pay Social Security and Medicare taxes in most cases. Your payments of these taxes contribute to your coverage under the U.S. Social Security system. Social Security coverage provides retirement benefits and medical insurance (Medicare) benefits to individuals who meet certain eligibility requirements. Your employer deducts these taxes from each wage payment. Your employer must deduct these taxes even if you do not expect to qualify for Social Security or Medicare benefits.

Standard Deduction

The standard deduction is a dollar amount that reduces the amount of income on which you are taxed. You cannot take the standard deduction if you claim itemized deductions. In some cases, your standard deduction can consist of two parts, the basic standard deduction and additional standard deduction amount, for age, or blindness, or both. In general, the basic standard deduction is adjusted each year for inflation and varies according to your filing status.

Taxable Income

Gross income (wages, tips, dividends, etc) minus any adjustments to income, any allowable exemptions, and either itemized deductions or the standard deduction.

Tax Year

The tax year is the time period covered by a tax return. Usually this is January 1 to December 31, a calendar year, but taxpayers can elect a fiscal tax year with different beginning and ending dates.

Tip Income

This is the amount of money received directly from a client for providing services. A good example of someone who works for tips is a waiter.

Travel Expenses

Travel expenses are the ordinary and necessary expenses of traveling away from home for your business, profession, or job.

Unearned Income

Unearned income is investment income such as interest, dividends, and capital gains.

Vacation Home

You are considered to use a dwelling unit as a home if you use it for personal purposes during the tax year for more than the greater of: 14 days or 10% of the total days it is rented to others at a fair rental price. It is possible that you will use more than one dwelling unit as a home during the year.

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