Tax accounting has a language all its own. You may never learn to speak it like a native, but knowing a few tax terms will help you feel less like a foreigner in your own country.
Accelerated cost recovery system (ACRS): A method of depreciation for 3-, 5-, 10, and 18-year property wherein the full percentage is allowed in the first year (no matter when during the year the property was purchased), varying percentages are allowed (as specified in the instructions for Form 4562) in subsequent years, and no percentage is allowed in the last year. Each year’s percentage is set by the IRS.
Accrual accounting: An accounting system wherein income and expenses are listed at the time of service, not of payment. Under accrual, you count income you’ve earned but not yet received and expenses you’ve incurred but not yet paid bills for. You can’t switch methods of accounting without permission from the IRS.
Adjusted gross income: The amount of your total income that remains after adjustments—such as moving expenses, employee business expenses, IRA or Keogh payments, penalties for early savings withdrawals, alimony paid, deductions for married couples with both working, and disability income exclusion—are subtracted. This amount must be reported on line 33 of Form 1040 and precedes either itemized deductions or the standard exclusion.
Allocation: A process wherein an expense is divided between two situations. One part may be deductible while the other isn’t. For example, a portion of the total cost of driving your personal automobile may be deductible as a business expense: The total cost of driving the car is allocated.
Amortization: A process similar to depreciation wherein income (such as bonds bought at discount) or expense (such as business startup costs) is spread over several tax years.
Basis: The cost from which profit is figured on the sale of property. Basis in a house, for example, is the amount originally paid plus capital improvements-minus depreciation allowed or taken.
Capital gain and loss: The profit or loss from property held for investment is figured by capital gain. Gains or losses from property held less than six months are considered short-term and are fully taxable or deductible (from other gains). Property sold after more than six months is long-term, and gain or loss is reduced to 40% of the amount.
Credit: Tax credits are deducted from the amount of tax paid, not from income. They are taken on lines 41 through 50 of Form 1040.
Deductions: Expenses declared on Schedule A by individual taxpayers and Schedule C by the self-employed. These may involve certain personal or employee-related costs. The alternative to itemizing deductions is the standard deduction (called the zero bracket amount).
Depreciation: A process by which a portion of the value of property that will wear out, lose value, or become obsolete may be deducted during each year of its life. Accelerated cost recovery is a method of depreciation.
Earned income: Money earned by gainful employment-as opposed to dividends, interest, or capital gains.
Exclusion: Certain types or portions of income may not be taxable. Exclusions are sometimes the same as adjustments.
Exemption: A consideration of the number of people dependent upon a taxpayer, including the taxpayer.
First-year expensing: Up to $5,000 of the cost of certain property bought for business use may be deducted in the year purchased. Depreciation and investment tax credit are alternatives.
Fiscal year: A 12-month accounting period different from the calendar year. Taxes need not be filed on the calendar year. A change of fiscal year must be approved by the IRS.
Gross income: Total income before any adjustments or deductions are subtracted.
Imputed interest: On certain transactions where no (or low) interest was charged (such as zero interest loans to family members), the IRS will calculate interest at the imputed rate, which is determined daily by the service itself.
Investment credit: 10% of the cost of business property that will last five years or more may be deducted in the year the equipment is purchased. Business property that is figured to last three years (cars, for example) entitles the purchaser to a credit equal to 6% of the cost.
Recapture: If property that is being or has been depreciated is sold for more than the basis in that property (cost, plus capital improvements, minus depreciation), the portion of the difference equal to the depreciation deduction must be reported as ordinary income. Thus the depreciation is recaptured. See special rules for recapture of first-year expensing if property is held less than two years and for investment tax credit if property is held less than five years.
Straight-line election: Property may be depreciated by claiming an equal percentage of its cost in each year of its life. For example, five-year property would be claimed at a rate of 20% each year, assuming that the property was put into service on January 1 of the first year of depreciation.
Zero bracket amount: The name the IRS uses for its alternative to itemizing deductions. (This formerly was called the standard deduction.) If you do not itemize, this amount is figured into the tax table you use. If you do itemize, the zero bracket amount must be subtracted from your total itemized deductions on Schedule A.