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Fundamentals
of Taxation
2009
Ana Cruz
Miami Dade College
Michael Deschamps
MiraCosta College
Frederick Niswander
East Carolina University
Debra Prendergast
Northwestern Business College
Dan Schisler
East Carolina University
Jinhee Trone
Santa Ana College
Boston Burr Ridge, IL Dubuque, IA New York San Francisco St. Louis
Bangkok Bogot Caracas Kuala Lumpur Lisbon London Madrid Mexico City
Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto
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FUNDAMENTALS OF TAXATION 2009
Published by McGraw-Hill/Irwin, a business unit of The McGraw-Hill Companies, Inc., 1221 Avenue of the
Americas, New York, NY, 10020. Copyright 2009, 2008, 2008 by The McGraw-Hill Companies, Inc. All
rights reserved. No part of this publication may be reproduced or distributed in any form or by any means, or
stored in a database or retrieval system, without the prior written consent of The McGraw-Hill Companies, Inc.,
including, but not limited to, in any network or other electronic storage or transmission, or broadcast for distance
learning.
Some ancillaries, including electronic and print components, may not be available to customers outside the
United States.
This book is printed on acid-free paper.
1 2 3 4 5 6 7 8 9 0 QPD/QPD 0 9 8
ISBN 978-0-07-337963-0
MHID 0-07-337963-8
ISSN 1933-8066
Vice president and editor-in-chief: Brent Gordon
Editorial director: Stewart Mattson
Publisher: Tim Vertovec
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www.mhhe.com
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I dedicate this work to my parents.
Ana Cruz
To my lovely wife Shannon for all of her support
and encouragement and to Norma, loving mother
and supporter, who was always there for us.
Michael Deschamps
To my wife Debi, who keeps me grounded.
Rick Niswander
To my husband, Jim, and to my children
Matthew, James, and Genevieve: You are
the parts that make me whole. I dedicate this
work to you.
Debra Prendergast
I would like to dedicate this text to my wife,
Debra, and my daughters Jessica and Samantha.
Dan Schisler
Dedicated to my husband, Darren, and my
children, Sean and Nikki, whose life and
enthusiasm are the source of my own.
Jinhee Trone
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As grand as Mount Rushmore appears to the millions
of tourists who visit the monument each year, the origi-
nal plans for the memorial were even more ambitious.
Historian Doane Robinson, who proposed the original
sculpture in 1925, intended to include the full torsos
of four presidents, plus the U.S. Constitution, Declara-
tion of Independence, and a rendering of the Louisiana
Purchase.
Not surprisingly, a lack of funds forced Robinson
and sculptor Gutzon Borglum to scale back the plans.
Instead, four presidents were chosen to represent the
leaders who most helped preserve the country and
expand its territory. Calvin Coolidge (the sitting Presi-
dent) noted that two Republicans and one Democrat
should be selected; the nal result loosely followed
these guidelines, with George Washington, Thomas
Jefferson, Abraham Lincoln, and Theodore Roosevelt earning a spot on the
mountain.
In total, the Mount Rushmore memorial cost $989,992.32 (of which, $836,000
was paid from government appropriations). This was relatively cheap in 1927,
when the top tax rate on regular income was just 25%. By the time the project was
completed, the top tax rate on regular income had soared to 80%!
To train tomorrows tax preparers to handle the complex U.S. tax law,
Fundamentals of Taxations author team has devised four primary teaching
advantages.
Fundamentals of Taxation 2009
Easy for my students to read and follow. Denitely a great book for individu-
als who will be involved with tax preparation. After taking a course using this
book, a student could easily handle the preparation of a tax return.
Andrea M. Murowski, Brookdale Community College
A Monumental New
Approach to Teaching Tax
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First, we organize the text to closely follow IRS tax forms. We introduce
students to standard IRS forms early and reinforce their use throughout the
text. Actual tax forms are incorporated throughout the text, giving stu-
dents the opportunity to understand the principles behind tax law while they
learn how to work with clients to obtain the information they will need to
complete tax forms.
Second, we illustrate the proper reporting of tax issues. We present a tax
issue, discuss the legal requirements, illustrate the proper tax form place-
ment, and show the completed form in the text. By effectively leading the
student through each issue, we demonstrate how tax form preparation is the
result of a careful process that balances legal knowledge with practical expe-
rience using tax forms.
Third, we integrate an individual income tax software package into the
text that is used in examples. We instruct students how to use the software
to complete returns using sample taxpayers who appear from chapter to
chapter. An important consideration in writing the textbook was to allow
instructor exibility. You can choose to rely heavily on the software, you can
incorporate the software only after you cover the law and the reporting, or
you can deemphasize the software component. This exible approach allows
you to structure your taxation course the way you want to!
Fourth, we supplement the text with citations of relevant tax authorities
such as the Internal Revenue Code, Treasury Regulations, revenue rulings,
revenue procedures, and court cases. These citations are almost always pro-
vided in footnotes. Thus, you and your students can easily use, or not use,
the footnote material.
Ana Cruz
Dr. Ana Cruz is Chair of the Business Department at Miami Dade College, Wolf-
son Campus, where she utilizes her extensive experience in the areas of general
business, management, accounting, and taxes. She has worked in the service,
retailing, and manufacturing industries, as well as in the federal government
sector, where she served as a eld examiner for the Internal Revenue Service.
Dr. Cruz, a Certied Public Accountant, has published several articles in busi-
ness journals and has received the Southeast Banking Corporation Foundation
Endowed Teaching Chair (1998) and the Wolfson Senior Foundation Endowed
Teaching Chair (2002). Her latest recognition was being named Professor of
the Year for the State of Florida by the Council for Advancement and Support of
Education and the Carnegie Foundation (2005).
1
2
3
4
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How Does Cruz Form a
Better Understanding of Tax?
Apendix B include comprehensive
problems for 1040 schedule A, B, C, D,
and E. Tee longer problems include
boh eas and di cult schedule to tet
students comprehension o a range o
topics covered acros multiple chapters.
Forms-Based Approach
The forms approach enables the student to see a direct connection among
the law, forms, and return preparation. This is an important connection and
one that many students struggle making [while] utilizing a text written from a
theory approach.
Karen Kettleson, Western Technical College
I love this textbook and have told all my
colleagues. It offers more forms not only for
completing the problems but illustrates more
input forms so students can learn how to gather
the information the taxpayer receives.
Marilyn G. Ciolino, Delgado
Community College
Example o compleed tax forms demonstrate how tax theory
covered in the te translate to real reurns.
Incorporation o real-world tax reurns
into the te for elecronic as well as
manual preparation force students to
learn hands-on skills.
FPO
The best tax textbook that I have seen.
Dawn W. Stevens, Northwest
Mississippi Community College
EXHIBIT A-1
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Michael P. Deschamps
Michael P. Deschamps received a Bachelor of Science degree in Accounting,
graduating magna cum laude from the University of San Diego, where he served
as the chapter president for Beta Alpha Psi, the international accounting honor
society. After working in public accounting and obtaining his CPA license, he
returned to San Diego State University, where he earned a Masters degree
in Taxation and a certicate in Financial Planning. In addition, he earned his
Enrolled Agent certicate in 2004. He is currently a professor of accounting at
MiraCosta College in Oceanside, CA and previously was a tenured professor of
accounting and nancial services at Chaffey College, where he also served as
the program coordinator for six years, developing a highly regarded tax pro-
gram. He is an active member of Teachers of Accounting at Two Year Colleges
(TACTYC) and was a presenter at the 2006 and 2007 national conventions.
He has published articles in both local and national publications and has given
presentations on tax issues to a variety of organizations.
Fundamentals of Taxation features an integrated tax software package from
TaxACT, one of the leading tax preparation software companies in the mar-
ket today. Students are instructed on the practical applications of tax soft-
ware, with exercises that teach how software can be used to prepare all types
of tax returns.
Sample taxpayers are used throughout the book, in varying situations, to
give students full exposure to the many types of tax preparation challenges
they will face. This exposure allows students to make the connection be-
tween the tax law, the software inputs, and the tax output on the appropri-
ate tax forms.
Fundamentals of Taxation also provides the instructor with the exibility
needed in an individual income tax course. Each chapter can be used with
or without the tax software, depending on the objectives of an individual
instructors course.
TaxACT features in-depth form instructions that supplement the textbook
material, making it easier than ever to integrate software into the classroom.
Students are provided with the latest tax forms via the Automatic Update
Wizard, so that at the start of the semester each student will be prepared
to work with the most up-to-date information available. With over 120 tax
forms, schedules, and worksheets, TaxACT is sure to have the course mate-
rials you will need throughout the semester.
Be sure to visit www.TaxACT.com today for more information!
software
I currently use
TaxACT for my tax
practice and I like
your choice.
Natasha Librizzi,
Milwaukee Area
Technical College
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How Does Cruz Better
Prepare My Students ?
Tax Your Brain
I think these are at a good point in the discussion to not only make the student
think but also to force the teacher to allow them to digest the topic.
Bill Kryshak, University of WisconsinStout
Te Tax Your Brain feature is deigned to work with the eample in the
te to reinforce the understanding o ke concepts. Students are given
information in an eample and then are asked to aply wat the have
learned to a dierent situation.

By asking the student to think critically about theorie and concepts,
wile suplying the answer right afer the quetion, the Tax Your Brain
eample provide anoher oportunity for hands-on eperience.
I use examples like this all of the time in my classes as a way to help students
apply concepts learned to various situations.
Joyce Grifn, Kansas City Kansas Community College
Use the information in Example 2-1 except assume that Mary and Peter each earned $20,000
from their university employment. Who is entitled to the dependency exemption?
ANSWER
No one. The joint tax return of Mary and Peter would show a tax liability. Thus, the Jeffersons
cannot claim the dependency exemption because Mary and Peter do not meet the joint return
test. Mary and Peter would not receive the dependency exemption either. The IRS deems that the
person or persons ling a tax return are not dependents. Mary and Peter would, however, each
be entitled to a personal exemption on their joint tax return. Note that the answer would be the
same even if Mary and Peter led separate returns.
TAX YOUR BRAIN
An individual meets the citizen or resident test if the perso i ith ( i
This text is straightforward, logically organized, student centered, and presents
fundamental tax concepts in a clear and concise manner.
William Lloyd, Lock Haven University
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Most importantly, students
learn how to apply what
they learned by preparing
tax returns at the end of the
chapter, and the bonus is
they learn how to use a tax
software. In 16 weeks, stu-
dents would have prepared
over 30 tax returns. This
is what attracts students to
enroll in the course. It not
only meets their require-
ment for their course of
studythey walk away
with a life skill.
Lolita M. Lockett,
Florida Community
College at Jacksonville
3-20 Chapter 3 Gross Income: Inclusions and Exclusions
We now introduce two new taxpayers.
YIMING CHOW
The rst taxpayer is Yiming Chow, who is single and lives
at 456 Maple Avenue, Somewhere, OH 45678. His SSN
is 111-11-1111. During 2006, Mr. Chow received a W-2
from his employer, a 1099-INT from the local nancial
institution, and a 1099-DIV associated with a mutual
fund investment. He also received a 1099-G from the
State of Ohio for a $57 tax refund pertaining to tax year
2005. Mr. Chow did not itemize his deductions in 2005.
All these documents are shown in Exhibit 3-9.
Open the tax software. Go to the File pull-down
menu and click on New Return. Go through the process
to start a new return, and then click on the Forms icon
to bring up the list of available forms. Open a Form 1040
to input the basic name, address, and Social Security
number information for Mr. Chow. He is eligible to le
Form 1040A, and we will use that form after you enter
his personal information.
Now enter the information from the various tax
forms into the tax software using the applicable forms
in the documents received section. Note that you do
not need to enter any information concerning the
tax refund. Mr. Chow did not itemize deductions in
2005, so you do not need to report his tax refund as
income.
Once you have entered the appropriate information,
click on Form 1040A. Line 15 should be $41,688. Line
27, taxable income, should be $33,238. Mr. Chows tax
liability on line 28 is $4,854. Because Mr. Chow has wage
income and dividend income, you may nd it instructive
to calculate the tax liability by hand to see if you get the
same answer. Because Mr. Chow had $5,070 withheld
from his wages, his refund is $246, as shown on lines
44 and 45a.
Make sure you save Mr. Chows return for use in later
chapters.
MR. AND MRS. RAMIREZ
The second taxpayer is the married couple Jose and
Maria Ramirez. They live at 1234 West Street, Mytown,
GA 33333. They have three children, Arturo, Benito,
and Carmen, born in 1993, 1995, and 1997, respectively.
The children lived in the household during the entire
year. The SSNs are as follows:
Jose 222-22-2222, Maria 333-33-3333
Arturo 222-22-0001, Benito 333-33-0001, Carmen
444-44-0001
Mr. Ramirez received a W-2 from his employer, a
1099-INT from the nancial institution, and a 1099-DIV
from his stockbroker. He also received a 1099-G from
the State of Georgia for a $645 tax refund. The taxpayer
itemized deductions last year and you have determined
that the entire refund is taxable.
All of the Ramirezes documents are shown in Exhibit
3-10.
Open the tax software. Go to the File pull-down
menu and click on New Return. Go through the process
to start a new return,and then click on the Forms icon
to bring up the list of available forms. Open a blank
Form 1040 to input the basic name, address, and social
security number information for Mr. and Mrs. Ramirez.
Use the Dependent Worksheet in the Worksheet section
to enter information for the children.
The Ramirezes must le Form 1040 because of the
dividend income and state tax refund. For now, we
will assume that the couple will take the standard
deduction.
Now enter the information from the various tax
forms into the tax software using the applicable forms
in the documents received section.
Because you do not have tax return information
for tax year 2005, you need to provide information
concerning the tax refund. Enter in the system that the
full amount of the refund is taxable.
Once you have entered the appropriate information,
the total income and the AGI of the taxpayer should
be $106,962. After subtracting a standard deduction of
$10,300 and personal exemptions of $16,500 ($3,300
per individual), taxable income should be $80,162.
Tax on line 44 should be $13,120. The tax software
automatically calculated a $3,000 child tax credit on
line 53. We will discuss credits later in the book. The
credit reduces the Ramirezes tax liability to $10,120.
Because the taxpayer had withholdings of $10,218, the
Ramirezes return should show a refund of $158 on
lines 73 and 74a.
Make sure you save the Ramirezes tax return for use
in later chapters.
From Shoebox to Software Two Comprehensive Examples
From Shoebox to Software
Te From Shoebox to So ware eample in each chapter help students
understand how the start with a ma o paper provided by a client
and proceed to a compleed tax reurn using tax so ware. Te student
can actually see the jump fom the theoreical tax world to practical
aplication.
Te simulation
o real-world situations in
each Shoebox eample helps
students beome proe-
sional tax preparers. Teir
frst day o work is far le
stre ful beause it is no
the frst time the have
seen a Form 1040 or a
Schedule D. Te are far
more productive beause
the know were to start
and how to complee the
work.
Frederick Niswander
Dr. Frederick (Rick) Niswander is Dean of the College of Business and the
W. Howard Rooks Distinguished Professor at East Carolina University. He holds a
Doctor of Philosophy degree from Texas A&M University and a Bachelor of Sci-
ence in Business Administration degree from Idaho State University. He has taught
introductory nancial accounting, international accounting, intermediate account-
ing, and a graduate accounting course that encompasses taxation, nancial, and
governmental accounting. Prior to obtaining his doctorate and joining the ECU
faculty in 1993, he was the Chief Financial Ofcer of a privately held real estate
company in Phoenix, Arizona, for eight years. Dr. Niswander has been a CPA in
North Carolina since 1994 and in Arizona since 1981. He is a member of the
North Carolina Association of CPAs, the American Institute of Certied Public
Accountants, and the American Accounting Association. He is also the immediate
past chairman of the NCACPA, an 11,000-member statewide CPA organization.
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c. The wages of a minister who
d. The wages of an inmate working in the prison laundry.
43. What are some of the limitations concerning deductibility of student loan interest? Be
specic and comprehensive.
44. Discuss the characteristics of an eligible educational institution as it relates to the
deductibility of student loan interest.
45. Barbara attended State University during 20022006. She lived at home and was
h parents as a deduction during the entire duration of her education. She
llege of which $2,000 was paid for
d t
Problems
Problems LO 1 LO 1
LO 1 LO 1
LO 1 LO 1
p y
LO 2: Be able to calculate
the health savings account
deduction.
A health savings account (HSA) is a tax-exempt savings
account used to pay for qualied medical expenses.
To be eligible for an HSA, the taxpayer must be self-
employed or an employee (or spouse) of an employer with
a high deductible health plan.
Distributions from an HSA are tax free as long as they are
used to pay for qualied medical expenses.

LO 3: Determine the deduction

for moving expenses.
If someone moves due to a change in employment, certain
expenses related to moving may be deducted.
The costs of moving goods and people from the old
residence to the new residence are considered suitable
expenses.
The deductibility of moving expense is subject to both time
and distance tests.

This ling
Even though you are in the process of getting a divorce, you can le as married ling jointly.
True or False?
The social security number of the taxpayers spouse must be shown on the taxpayers tax
return when ling married ling separately. True or False?
A surviving spouse who quali ed as married ling jointly when the spouse died can le as
a qualifying widow(er) for the next two years as long as the surviving spouse pays for more
than half the cost of keeping up a household and does not remarry. True or False?
1.
2.
3.
CONCEPT
CHECK 2-2LO 2

How Does Cruz Provide a

Clear Path to Student Success?
Clear Objectives for Your Students
Learning income tax reurn preparation require con-
stant reinforcement and practice. Te authors have
se up Fundamentals o Taxation to provide an
eas-to-follow format starting with a li o learning
obecive, wich are then repeated throughout the
book were the related material apears.
generally provide citations to the Internal
(IRC) and other tax law or regulations. You can read this book either with
or without the footnotes. If you would like to become familiar with the IRC and other
tax authority, the footnotes are a very good place to start exploring. Learning Objectives
When you have completed this chapter, you should be able to master the following
Learning Objectives (LO):
LO 1. Understand progressive, proportional, and regressive tax structures
LO 2. Understand the concepts of average and marginal tax rates as well as a simple
income tax formula.
LO 3. Understand the components of a 1040EZ income tax return.
LO 4. Determine tax liability in instances when a 1040EZ return is appropriate.
LO 5. Understand the types of tax authority and how they interrelate (Appendix A).
The fede l
ON ON
Concept Cheks are mini-quizze
that tet understanding o each
obecive.
A summary o the learning obecive ap-
pears at the end o each chapter, providing
a quick reference chart for students as the
prepare for eams.
Te same learning obetive are also ref-
erenced in the end-o-chapter material
net to each discusion quetion, multiple-
choice quetion, and problem.
The textbook is perfect for my classroom presentation:
It is easy reading for students.
Jose L. Duenas, Texas State Technical College
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14. In January 2007, Jeff incurred $1,200 of moving expenses when he moved from Des
Moines to Detroit. When he moved, he had no job but found one a week after moving. He
stayed on that job for two months, changed to another job for four months, and changed
again to a long-term position that he held for the remainder of the year. What is the
amount of moving expense deduction Jeff can report in 2007, if any?
LO 3 LO 3
Robust & Relevant End-of-Chapter Material
Fundamentals of Taxation offers a robust selection of end-of-chapter material.
Debra Prendergast
Dr. Debra Prendergast has a Doctor of Philosophy degree in Public Policy from the
University of Illinois at Chicago, a Masters of Business Administration degree from
Governors State University, and a Bachelor of Arts degree in Business Administra-
tion with a concentration in Accounting from Saint Xavier University in Chicago.
She is a licensed and practicing Certied Public Accountant in Illinois and a Certi-
ed Management Accountant. She began her professional accounting career as
a management advisory services consultant with Grant Thornton before taking a
position as the controller for a corporation in Chicago. To spend more time with her
family, she left her controller position in 1988 and began teaching accounting at
Northwestern Business College, a private two-year college. In 2008, Dr. Prender-
gast became the Dean of Educational Programs in the School of Commerce at
Northwestern Business College. She serves as an ofcer on the board of
Teachers of Accounting at Two Year Colleges ( TACTYC ) and is on the
Pre-certication Education Executive committee of the AICPA.
Discusion Quetions tet the basic concepts o each chapter.
Students suply short answers to a variey o quetions
covering each o the major concepts in the chapter.
Multiple-Choice Quetions complement the discusion quetions as an alternative way to quick-
ly tet a variey o learning obecive. Te quetions range fom eas to more comple computa-
tional multiple choice.
Tax Reurn Problems incorporate
the TaxACT so ware and encourage
students to aply a range o concepts
the have learned throughout the
chapter. All Tax Reurn Problems
can also be done by hand. Te
authors indicate wich forms are
needed for each problem.
26. (Introduction) For AGI, or above-the-line, deductions:
a. Are determined by the taxpayer.
b. Are set by statute.
c. Increase tax liability.
d. Are reported in Schedule A.
27. (Introduction) For AGI, or above-the-line, deductions:
a. Increase AGI.
b. Reduce tax credits.
c. Are only available for MFJ.
d. Can reduce overall tax liability.
Multiple-
Choice
Questions
Multiple-
Choice
Questions
Use your tax software to complete the following problems. If you are manually preparing the
tax returns, you will need a Form 1040 for each problem.
Brenda carlyle attended Kansas State University during 20032007. She incurred educational
expenses of $10,000 of which $2,000 was paid for by scholarships. To nance her education,
she borrowed $7,000 through a federal student loan program and borrowed another $3,000
from a Kansas State Credit Union for educational purposes. After graduation, she accepted a
position with the Houston Deloitte & Touche ofce and moved there in June 2007. She lives
at 4560 Apple Blossom Lane with her cat, Misty.
Her W-2 contained the following information:
Wages of $61,533.05.
Federal Income Tax Withheld of $9,229.95. Social Security Wages of $61,533.05.
Social Security Tax Withheld of $3,815.05. Medicare Wages of $61,533.05.
Medicare Tax Withheld of $892 23
Tax Return
Problems
Tax Return
Problems
Tax Return
Problem 1
Tax Return
Problem 1
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How Does the Cruz Package
Provide Complete Support?
Instructor Resources
Instructors Resource Manual
This manual provides for each chapter (1) a chapter summary
that highlights the key points of each learning objective, (2) a
brief topical and lecture outline, (3) ethics cases, (4) suggestions
for group, Internet, and other class exercises to supplement the
material in the book.
Solutions Manual
The Solutions Manual includes detailed solutions for every
discussion question, exercise, problem, and case in the text.
Testbank
Fundamentals of Taxations comprehensive Testbank contains
more than 900 multiple-choice questions, problems, and essay
questions.
PowerPoint

Slides
The PowerPoint presentations serve as a visual representation of
the learning objectives and key points in each chapter. The slides
are available on the Online Learning Center (OLC).
Complete, practical and hands-on coverage of the material. The text is well
laid-out, student friendly with great practice quizzes and examples, and very
good instructor resources.
John Striebich, Monroe Community College
Fundamentals of Taxation authors Cruz, Deschamps, Niswander, Prendergast,
Schisler, and Trone know that every component of the learning package must be
integrated and supported by strong ancillaries. Critical to any successful ancillary
package is author involvement. For this reason, the author team writes all instructor
resources that accompany Fundamentals of Taxation.
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Online Learning Center (OLC)
www.mhhe.com/cruz2009
The Online Learning Center (OLC) that
accompanies Fundamentals of Taxation provides
a wealth of extra material for both instructors and
students. With content specic to each chapter
of the book, the Cruz OLC is available to help
students tackle a wide range of topics. It does
not require any building or maintenance on your
part and is ready to go the moment you and your
students type in the URL.
As students study, they can refer to the OLC for such benets as:
Dan Schisler
Dr. Dan Schisler is currently the Chair of the Accounting Department at East
Carolina University. He holds a Doctor of Philosophy degree from Memphis State
University, a Masters Degree in AccountingTax Concentration from Auburn
University, and a Bachelor of Science degree in Accounting from Southeastern
Louisiana University. In addition to public accounting experience with Peat
Marwick Main & Co, Dr. Schisler has published numerous articles in national
academic and practitioner journals such as Journal of the American Taxation As-
sociation, Advances in Taxation, and Accounting Horizons. He teaches tax and
accounting at the graduate and undergraduate levels at East Carolina where he
has been recognized for teaching excellence by numerous teaching awards at
the department, school, and university levels. Dr. Schisler holds CPA certicates
in North Carolina and Louisiana.
Self-grading multiple-choice quizzes.
Electronic ashcards.
PowerPoint

presentations.
Links to professional resources.
Tax law updates.
A secure Instructor Resource Center stores your essential course materials to save
you prep time before class. The Instructors Manual, Solutions Manual, PowerPoint

presentations, Testbank, and sample syllabi are now just a couple of clicks away. You
will also nd useful packaging information about other available supplements.
cru79344_wt.indd xiii 10/10/08 8:27:46 PM
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Acknowledgments
Writing a textbook is always a collaborative effort among authors, the publisher, authors fami-
lies, and instructors. The professors listed here contributed their time and insight to help this
new edition launch successfully. By attending focus groups, reviewing selected chapters, reading
through the whole manuscript, and reviewing page proofs, they contributed careful observations
that enabled us to make signicant improvements. Each person contributed something different,
either a well-deserved criticism or a helpful word of encouragement. We sincerely appreciate
their help and professionalism:
Donna Ascenzi, Bryant & Stratton College
Felicia Baldwin, Richard J. Daley College
Amy D. Bentley, Tallahassee Community College
Margaret Black, San Jacinto College
Vickie Boeder, Madison Area Technical College
Watertown
Anna Boulware, St. Charles Co. Community College
Teresa Brown, Penn Valley Community College
Amy Chataginer, Miss. Gulf Coast Community
CollegeGulfport
Marilyn Ciolino, Delgado Community College
John Daugherty, Pitt Community College
Judy Daulton, Piedmont Technical College
Patricia Davis, Keystone College
Peggy DeJong, Kirkwood Community College
Ken Dennis, San Diego City College
Norris Dorsey, California State University
Jose Duenas, Texas State Tech College
Debbie Gahr, Waukesha County Technical College
Drew M. Goodson, Central Carolina Community
College
Joyce Grifn, Kansas City Kansas Community
College
Keith Hendrick, De Kalb Technical College
Merrily Hoffman, San Jacinto College
Carol Hutchinson, Asheville-Buncombe Tech
Benjamin W. Johnson, Oakland City University
Joseph Kabacinski, DYouville College
Dieter M. Kiefer, American River College
Bill Kryshak, University of WisconsinStout
Jennifer Lesure, Ivy Tech Community College of
Indiana
Natasha Librizzi, Milwaukee Area Technical
CollegeMilwaukee
Bill Lloyd, Lock Haven University of Pennsylvania
Lolita Lockett, Florida Community College at
Jacksonville
Kim Miller, Tri-State University
Jennie L. Mitchell, St. Mary of the Woods College
Andrea M. Murowski, Brookdale Community
College
Michelle Nickla, Ivy Tech Community College of
Indiana
Jon Nitschke, Montana State UniversityGreat
Falls
Tracie Nobles, Austin Community College
Ron OBrien, Fayetteville Tech
Louis O. Okonkwo, Manatee Community College
William A. Padley, Madison Area Technical
CollegeMadison
Deanne Pannell, Pellissippi State Tech
Cynthia L. Phipps, Lake Land College
La Vonda Ramey, Schoolcraft College
A Monumental Development Effort
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Jinhee Trone
Jinhee Trone is the Chair of Business Administration and Professor of Accounting
at Santa Ana College. She received a Bachelor of Science degree in Business
Administration from California State University of Los Angeles. A licensed CPA in
California, she has taught various tax and nancial and managerial accounting
courses at Santa Ana College. Prior to academics, she was an audit manager
for the Los Angeles ofce of Ernst & Young, LLP, and a nancial and manage-
ment consultant.
Patrick Rogan, Cosumnes River College
Sheryl H. Rogers, Ogeechee Technical College
Luis Sanchez, Sierra College
Warren Smock, Ivy Tech Community College of
Indiana
Dawn Stevens, Northwest Mississippi College
John Striebich, Monroe Community College
Teresa Thamer, Brenau University
Hong Trebesh, Lansing Community College
Alan Viersen, MiraCosta College
Tonya Waters, Western Piedmont Community
College
Mary Ellen Wells, Alvernia College
Barbara Wergeles, State Fair Community College
Lloyd White, Clover Park Technical College
Tim Whited, National College
Jane Wiese, Valencia Community College
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A special thank you to Jeanine Metzler of the
Northhampton Community College for her excellent
work on the Conversion Guide for the 2008 editionher
enthusiasm for the book is much appreciated!
We greatly appreciate the accuracy checking work
completed by Marilyn Headrick (Lincoln University of
Missouri) and William A. Padley (Madison Area Technical
CollegeMadison). Their attention to detail has greatly
inuenced the accuracy of the 2009 edition. Many thanks also
go to Kim Watkins of East Carolina University, who assisted
in the preparation of the tax forms used throughout the book.
We also appreciate the expert attention given to this
project by the staff at McGraw-Hill/Irwin, especially
Stewart Mattson, Editorial Director; Tim Vertovec,
Publisher; Daryl Horrocks, Developmental Editor; Scott
Bishop, Marketing Manager; Harvey Yep and Erika Jordan,
Project Managers; Balaji Sundararaman, Media Product
Manager; Matt Baldwin, Lead Designer; and Gina Hangos,
Production Supervisor.
Ana Cruz
Michael Dechamps
Rick Niswander
Debra Prendergast
Dan Schisler
Jinhee Trone
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xvii
Assurance of Accuracy
Dear Colleague,
As textbook authors, and more importantly, as instructors of taxation, we recognize the great
importance placed on accuracynot only in the book you are now holding, but in the supple-
ments as well. With this in mind, we have taken the following steps to ensure that Fundamentals
of Taxation is error-free:
We received detailed feedback from dozens of instructor reviews. Each review contributed
in signicant ways to the accuracy of the content.
Each of us wrote, reviewed, and carefully checked the end-of-chapter material.
Multiple accuracy checkers reviewed each chapter and its accompanying end-of-chapter
materialonce when the nal manuscript was submitted to the publisher, and again when
our nal formatted pages were completed.
A copyeditor checked the grammar of the nal manuscript.
A proofreader reviewed each pageproof to ensure no errors remained.
Our Solutions Manual and Testbank were created by the authors and reviewed by multiple
independent accuracy checkers.
Given the steps taken above, we have the utmost condence that you and your students will
have a great experience using Fundamentals of Taxation.
Sincerely,
Ana Cruz
Mike Deschamps
Rick Niswander
Dan Schisler
Debra Prendergast
Jinhee Trone
1.
2.
3.
4.
5.
6.
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xviii
CHANGES IN FUNDAMENTALS OF TAXATION, 2009 EDITION
For the 2009 edition of Fundamentals of Taxation, the Cruz author team has spent considerable
time making careful revisions to the textbook and its supplements. These specic enhance-
ments have been made in the 2009 edition:
All chapters and tax forms have been updated for new tax law, making them current through
September of 2008. Other updates beyond September can be found on the books Online
Learning Center, www.mhhe.com/cruz2009.
Two independent accuracy checkers read every page of the manuscript, pageproof and
solutions manual to ensure that there were no errors. Each tax return problem, exhibit, and
example was carefully checked to make sure that the calculations and form references were
accurate.
In addition, the Testbank, online quizzes, and review questions online were all checked for
accuracy by an independent reviewer.
In the Solutions Manual, problems and multiple choice questions involving calculations
now include detailed descriptions of how those calculations were made.
For all chapters and comprehensive problems, social security numbers and addresses are
now included where needed.
More detail on ling deadlines and extensions has been added to Chapter 1 (see page 1-17).
A chart comparing the 1040 and 1040A forms has been added to Chapter 2 (see page 2-7),
New coverage of the Penalty for Erroneous Claim for Refund or Credit has been added
to Chapter 2 (see page 2-27).
More coverage of qualied education expenses has been added to Chapter 4 (see page
4-3). Also, the coverage of Health Savings Account deductions was revised on page 4-6 and
moving expenses was revised on 4-9.
More coverage of investment interest was added to page 5-18, and more coverage of prop-
erty damage was added to page 5-30.
New coverage of the Economic Stimulus Act of 2008 is included on page 6-15.
The coverage of Capital Gain Rates on page 7-10 was revised.
All coverage of Residential Energy Credits was deleted in Chapter 9.
New examples were added with completed 941 (Example 10-13) and Schedule H (Example
10-16) forms.
A new table for ordinary life annuities was added to the appendix of Chapter 11.
Examples 11-11 through 11-16 were replaced with new examples.
A new Appendix A has been added, covering Amended Returns and the Form 1040X.

xviii
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AS WE GO TO PRESS
This book is completed in mid-October and printed in early December. We picked that pub-
lication date to provide you a book that is as up-to-date as possible. A consequence of using
that timeframe is that Congress or the IRS may change some aspect of the tax law (especially
around year-end or election time) that will affect the material in this book. Thus, we provide
this page to inform you of items that change at the last minute. You can also go to our website
for changes that occur even later.
On October 3, 2008, the president signed into law the Emergency Economic Stabilization
Act of 2008 (H.R. 1424). Although the primary purpose of this bill was to help nancial
institutions and credit markets with emergency assistance of up to $700 billion, the bill also
included a number of tax provisions that affect 2008 and later years.
The signicant tax law changes that are likely to affect a wide range of taxpayers have been
incorporated in this text. For example, we have incorporated the new exemption amounts for
Alternative Minimum Tax (Chapter 13), the deduction for state and local sales tax in lieu of
state income tax (Chapter 5), and for AGI deductions for higher education expenses and edu-
cator expenses (Chapter 4).
The Act also provided tax relief for affected taxpayers in federally declared disaster areas
in 2008 and 2009, including special provisions for 2008 disaster victims in ten Midwestern
states. These disaster relief provisions include a waiver of the 10% of AGI casualty loss limi-
tation, liberalized IRA and retirement plan rules, additional personal exemption for certain
housing costs, and increased education credit amounts. These disaster-related tax provisions
are not included in this book primarily because they are specialized and generally beyond the
scope of the text.
These last-minute tax changes illustrate one of the facts of life for tax professionalstax
laws change every year and some of those changes occur at the last minute. As potential tax
professionals, you need to understand the dynamic nature of the tax law and be able to accom-
modate changes into your work.
Ana Cruz
Michael Deschamps
Rick Niswander
Debra Prendergast
Dan Schisler
Jinhee Trone
xix
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xx
Contents
Chapter 1
Introduction to Taxation, the
Income Tax Formula, and Form
1040EZ 1-1
Tax Rate Structures 1-2
Marginal Tax Rates and Average Tax
Rates 1-5
A Simple Income Tax Formula 1-5
The Components of Form 1040EZ 1-6
Calculation of Tax (line 10, Form 1040EZ) 1-10
Tax Payments (line 9, Form 1040EZ) 1-12
Appendix A: Tax Authority 1-17
Appendix B: Getting Started with TaxACT 1-22
Chapter 2
Expanded Tax Formula, Forms
1040A and 1040, and Basic
Concepts 2-1
The Income Tax Formula and Forms
1040A and 1040 2-2
Filing Status (lines 15 on Forms
1040A and 1040) 2-9
Personal Exemptions (lines 6ab on Forms 1040A
and 1040) 2-11
Dependency Exemptions (line 6c on Forms 1040A and
1040) 2-12
Standard Deduction (line 24 on Form 1040A or line 40
on Form 1040) 2-18
Tax Due to IRS 2-19
Interest and Tax Penalties 2-23
Chapter 3
Gross Income: Inclusions
and Exclusions 3-1
When and How to Record
Income 3-1
Cash Method of Accounting 3-3
Taxability of Components of Gross Income 3-4
Items Excluded from Gross Income 3-16
Appendix: Tax Accounting for Savings Bond Interest
Used for Education Expenses, Below-Market Interest
Loans, Gift Loans, and Original-Issue Discount
Debt 3-24
Chapter 4
Adjustments for Adjusted
Gross Income 4-1
Student Loan Interest (line 33 on
Form 1040 or line 18 on Form
1040A) 4-2
Health Savings Account Deduction (Form 1040,
line 25) 4-6
Moving Expenses (line 26 on Form 1040) 4-9
Deduction for Half of Self-Employment Tax (line 27 on
Form 1040) 4-11
Self-Employed Health Insurance Deduction (line 29 on
Form 1040) 4-13
Penalty on Early Withdrawal of Savings (line 30 on
Form 1040) 4-14
Alimony Paid (line 31a on Form 1040) 4-15
Educator Expenses (line 23 on Form 1040) 4-18
Tuition and Fees Deduction (line 34 on Form 1040) 4-18
Chapter 5
Itemized Deductions 5-1
Deductible Medical Expenses (line 4
on Schedule A) 5-3
Deductible State and Local Taxes
(line 9 of Schedule A) 5-10
Deductible Interest (line 15 of Schedule A) 5-15
Deductible Gifts to Charity (line 19 of
Schedule A) 5-18
Deductible Casualty and Theft Losses (line 20 of
Schedule A) 5-23
Miscellaneous Itemized Deductions (line 27 of
Schedule A) 5-30
Limitation of Total Itemized Deductions (line 29 of
Schedule A) 5-31
Chapter 6
Self-Employed Business
Income (Line 12, Form 1040
and Schedule C) 6-1
Income for a Schedule C Trade
or Business 6-4
Ordinary and Necessary Trade or Business
Expenses 6-7
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Depreciation 6-8
Transportation and Travel 6-18
Business Use of the Home and Business Bad
Debts 6-27
Hobby Loss Rules and Education Expenses 6-33
Self-Employment Tax 6-34
Appendix: General Depreciation System 6-44
Chapter 7
Capital Gains and Other Sales
of Property (Schedule D and
Form 4797) 7-1
Terms and Tax Forms 7-2
Classication of Assets 7-4
Sales of Ordinary Assets 7-6
Sales of Capital Assets 7-9
Sales of Business Property 7-18
Tax Issues for Special Types of Sales 7-23
Chapter 8
Rental Property, Royalties, and
Income from Flow-Through
Entities (Line 17, Form 1040
and Schedule E) 8-1
Rental Property 8-2
Rental of Vacation Homes 8-9
Royalty Income 8-16
Flow-Through Entities 8-17
Chapter 9
Tax Credits (Lines 47 through
54 and Line 64a, Form
1040) 9-1
Credit for Child and Dependent
Care Expenses (Form 1040, line 48
[Form 2441] or Form 1040A, line 29
[Schedule 2]) 9-2
Credit for the Elderly or the Disabled (Form 1040, line
49 [and Schedule R] or Form 1040A, line 30
[Schedule 3]) 9-6
Education Credits (Form 1040, line 50 [and Form 8863]
or Form 1040A, line 31) 9-7
Foreign Tax Credit (FTC) (Form 1040, line 47 and Form
1116) 9-13
Child Tax Credit (Form 1040, line 52 or Form 1040A,
line 32) 9-16
Retirement Savings Contributions Credit (Form 1040,
line 51 [and Form 8880] or Form 1040A, line 33) 9-17
Adoption Credit (Form 1040, line 53 and Form 8839) 9-19
Earned Income Credit (EIC) (Form 1040, line 64a or
Form 1040A, line 40a) 9-20
First-Time Homebuyers Credit (Form 1040, line 69 and
Form 5405) 9-24
Appendix: 2008 Earned Income Credit (EIC) Tables 9-29
Chapter 10
Payroll Taxes 10-1
Tax Issues Associated with Payroll
and Form 1040 10-1
Federal Income Tax Withholding,
Social Security, and Medicare Taxes
on Wages and Tips 10-2
Reporting and Paying Payroll Taxes 10-10
Self-Employment Taxes, Unemployment Taxes, Form
940, Taxes for Household Employees, and
Schedule H 10-17
Employer Payroll Reporting Requirements Including
Forms W-2 and W-3 10-24
Supplemental Wage Payments, Backup Withholding,
Form W-9, Estimated Tax Payments, and Form
1040-ES 10-26
Appendix: Withholding Tables 10-41
Chapter 11
Retirement and Other
Tax-Deferred Plans and
Annuities 11-1
Tax-Deferred Plans and Annuities:
The Basics 11-1
Employer-Sponsored Retirement Plans 11-3
Individual-Sponsored Retirement Plans 11-9
Tax-Deferred Nonretirement Plans 11-12
Distributions from Tax-Deferred Pension Plans 11-13
Tax Treatment of Annuity Contracts 11-21
Appendix: Life Expectancy Tables 11-26
Chapter 12
Special Property
Transactions 12-1
Like-Kind Exchanges 12-2
Involuntary Conversions 12-7
Installment Sales 12-13
Sale of a Personal Residence 12-16
Related-Party Losses and Wash Sales 12-21
Contents xxi
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xxii Contents
Chapter 13
At-Risk/Passive Activity Loss
Rules and the Individual
Alternative Minimum
Tax 13-1
At-Risk Rules 13-2
Passive Activity Losses 13-9
At-Risk and PAL Rules in Conjunction 13-16
Alternative Minimum Tax (AMT) 13-20
Appendix: Depreciation Tables 13-35
Chapter 14
Partnership Taxation 14-1
Formation of a Partnership 14-1
Partnership Ordinary Income or
Loss 14-6
Separately Stated Items 14-12
Basis of the Partnership
Interest 14-16
Partnership Distributions 14-18
Disposal or Liquidation of a Partnership Interest 14-20
Chapter 15
Corporate Taxation 15-1
Corporate Formation and Filing
Requirements 15-1
Basis 15-2
Taxable Income and Tax
Liability 15-9
Transactions with Shareholders 15-14
Schedules L, M-1, and M-3 15-16
Other Corporate Issues Including Alternative
Minimum Tax 15-17
Subchapter S Corporations 15-20
Appendix A: Amended Returns
(Form 1040X) A-1
Appendix B: Comprehensive Problems B-1
Appendix C: Concept Check Answers C-1
Appendix D: Tax Tables D-1
Appendix E: Tax Forms E-1
Index I-1
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Fundamentals
of Taxation
2009

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