Chapter 04

1. Chapter 04 Individual Income Tax Overview

2. Individual Income Tax Formula • Gross income • Minus: For AGI deductions • Equals Adjusted gross income • Minus: From AGI deductions: • Greater of (a) Standard deduction or (b) Itemized deductions and • Personal and dependency exemption • Equals Taxable income

3. Individual Income Tax Formula • Taxable income • Times: Tax rates • Equals: Income tax liability • Add: Other taxes • Equals: Total tax • Minus: Credits • Minus: Prepayments • Equals: Taxes due or (refund)

4. Individual Income Tax Formula • Individuals report taxable income to the IRS • Reported on Form 1040 • U.S. tax laws use all-inclusive income concept • Realized income • measurable change in property rights • All realized income included in gross income unless specifically excluded or deferred • Recognized income • Reported on tax return

5. Individual Income Tax Formula • Excluded and Deferred income not included in gross income • Excluded income • Income never included in taxable income • Municipal bond interest • Gain on sale of personal residence • Deferred income • Income included in a subsequent tax year • Installment sales • Like-kind exchanges

6. Individual Income Tax Formula • Character of income or loss • Determines rates applicable to income or loss in current year • Tax exempt – no tax • Tax deferred – no tax in current year • Ordinary – ordinary rates from tax rate schedule • Qualified dividends – 0 or 15% • Capital gain or loss – depends on whether short-term or long-term • From selling capital asset • If held capital asset more than a year gain or loss is long-term, otherwise it is short-term

7. Individual Income Tax Formula • Capital assets • Generally all assets except • Accounts receivable • Inventory • Assets used in trade or business, including supplies

8. Individual Income Tax Formula • Capital gains and losses • Long-term capital gains generally taxed at 0%, 15%, or 20% depending on the taxpayer’s taxable income • Short-term capital gains taxed at ordinary rates • Net capital losses (losses in excess of gains for year) • $3,000 deductible against ordinary income for year • Losses in excess of $3,000 carried forward

9. Individual Income Tax Formula • Deductions for AGI • Deductions “above the line” • Deducted in determining adjusted gross income • Always reduce taxable income dollar for dollar

10. Individual Income Tax Formula • Deductions from AGI • Deductions “below the line” • Deducted from adjusted gross income to determine taxable income • Greater of standard deduction or itemized deductions • Personal and dependency exemptions • Why might a from AGI deduction not reduce taxable income?

11. Individual Income Tax Formula • 2013 Standard deduction amounts • $12,200 Married filing jointly • $12,200 Qualifying widow or widower • $6,100 Married filing separately • $8,950 Head of household • $6,100 Single • Additional standard deduction amounts for age and eyesight (discuss in Chapter 6)

12. Individual Income Tax Formula • Tax calculation • The U.S. uses a progressive tax rate schedule • Some items are taxed at preferential rates • Long-term capital gains • Qualified dividends • Tax on these items is calculated separately from income taxed at ordinary rates.

13. Individual Income Tax Formula • Other taxes include: • Alternative minimum tax • Self-employment taxes • Medicare Contribution tax on net-investment income • Tax credits • Reduce tax liability dollar for dollar

14. Individual Income Tax Formula • Tax prepayments • Payments already made towards tax liability including: • Income taxes withheld from wages by employer • Estimated tax payments made during the year • Taxes overpaid in prior year and applied toward current year’s liability • If prepayments exceed tax liability after credits, taxpayer receives a refund

15. Personal and Dependency Exemptions • Personal exemptions • For taxpayer and spouse if married filing jointly • Dependency exemptions • For those who qualify as the taxpayers’ dependents • Exemption amount for 2013 is $3,900

16. Personal and Dependency Exemptions • Dependency requirements • Citizen of U.S. or resident of U.S., Canada, or Mexico • Must not file joint return with spouse • Exception – if no tax liability filing jointly or separately • Must be qualifying child or qualifying relative of taxpayer

17. Personal and Dependency Exemptions • Qualifying child • Relationship test • Age test • Residence test • Support test

18. Qualifying Child • Relationship test • taxpayer’s son, daughter, stepchild, an eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister or a descendant of any of these relatives.

19. Qualifying Child • Age test: child must be younger than the individual claiming the child as a qualifying child and either- • under age 19 at the end of the year, • under age 24 at the end of the year and a full-time student, or • permanently and totally disabled.

20. Qualifying Child • Residence test • Same residence as taxpayer for more than half the year • Exception for temporary absences such as education. • Support test • Child must not provide more than half of his or her own support • Scholarships of actual child (not grandchild, for example) are excluded from support computation

21. Qualifying Child Example Rodney and Anita have two children: Braxton, age 12, who lives at home and Tara, age 21 who is a full-time student and does not live at home. While Tara earned $9,000 in a summer job, she did not provide more than half of her own support during the year. Are Braxton and Tara qualifying children to Rodney and Anita?

22. Qualifying Child Example Solution

23. Qualifying Child • Tie breaking rules • Parents first • Days living with each parent if parents living apart • AGI– higher AGI gets exemption

24. Qualifying Child Example Braxton’s uncle Shawn (Rodney’s brother) lived in the Halls’s home (the same home Braxton lived in) for more than 11 months during 2013. Does Braxton meet the requirements to be considered Shawn’s qualifying child?

25. Qualifying Child Example Solution

26. Qualifying Child Example Braxton is considered to be Rodney and Anita’s qualifying child and he is considered to be Shawn’s qualifying child. Under the tiebreaker rules, who is allowed to claim Braxton as a dependent for the year?

27. Qualifying Child Example Solution Answer: Rodney and Anita. Under the first tiebreaking rule, Rodney and Anita are allowed to claim the dependency exemption for Braxton because they are Braxton’s parents.

28. Personal and Dependency Exemptions • Qualifying relative • Relationship test • Support test • Gross income test

29. Qualifying Relative • Relationship test • a descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent), • a sibling of the taxpayer or a stepmother, stepfather, stepbrother, stepsister, nephew, niece, aunt, uncle (but cousins do not qualify) • in-law (mother-in-law, father-in-law, sister-in-law, brother-in-law, son-in-law, and daughter-in-law) of the taxpayer, or • unrelated person who lives in taxpayer’s home entire year (cousins may qualify this)

30. Qualifying Relative • Support test • Taxpayer must pay > ½ of living expenses (support) • Scholarships of actual child excluded • Gross income test • Gross income < personal exemption amount

31. Dependency Exemption Example • John is a 22-year old student who has lived in the dorms for most of the year but spends the rest of the year living with his parents. He earned a $5,000 scholarship for the school year and has worked hard to support himself through school earning $6,000 to pay for his own expenses. His parents have supported him by paying for $7,000 for food, clothing, and lodging expenses. Are John’s parents able to claim him as a dependent?

32. Dependency Exemption Example Solution

33. Personal and Dependency Exemptions

34. Filing Status • Five different filing statuses • Married filing jointly • Married filing separately • Qualifying widow or widower (surviving spouse) • Single • Head of household

35. Filing Status • Married filing jointly • Must be married on the last day of the year • If one spouse dies the surviving spouse is considered to be married to decedent spouse at year end • Exception – The surviving spouse remarries before year end • Joint and several liability for tax

36. Filing Status • Married filing separately • Taxpayers are married but file separate returns • Typically not beneficial from tax perspective • Tax rates and other tax benefits • May be beneficial for non-tax reasons • No joint and several liability

37. Filing Status • Qualifying widow or widower • Available for the two years following the year of spouse’s death • Surviving spouse does not qualify if remarries during two-year period. • Surviving spouse must maintain household for dependent child

38. Filing Status • Single • Unmarried unless qualify for head of household

39. Filing Status • Head of household • Unmarried or considered unmarried at end of year • See abandoned spouse discussion • Not a qualifying widow or widower • Pay more than half the costs of keeping up a home during the year • Lived in taxpayer’s home with a “qualifying person” for more than half of the year • Exception for parents (see below)

40. Filing Status • Qualifying person • Qualifying child • Qualifying relative who is taxpayer’s mother or father • Parent need not live with taxpayer • Taxpayer must pay > ½ cost of maintaining separate household for taxpayer’s mother or father • Parent must qualify as taxpayer’s dependent

41. Filing Status • Qualifying relative who is not the taxpayer’s parent • Person must have lived with taxpayer for more than half the year • Must qualify as taxpayer’s dependent • Must be related to taxpayer through qualified family relationship • If related only because lived with taxpayer for entire year, not a qualified person.

42. Filing Status • Head of household • Married individuals treated as unmarried (abandoned spouse) if individual • Is married at end of year (or is not legally separated from the other spouse) • Does not file a joint tax return with the other spouse • Pays > ½ the cost of maintaining a household that serves as principal abode for qualifying child for more than half the year • Lived apart from the other spouse for the last six months of the year (other than temporary absences)

43. Filing Status Example Assume that last year Rodney passed away, and during the current year Anita did not remarry but maintained a household for Braxton and Tara, her dependent children. Under these circumstances, what would Anita’s filing status be?

44. Filing Status Example Answer: Qualifying widow

45. Filing Status Example Assume Rodney and Anita divorced last year. During the current year, Braxton lives with Anita and Anita pays all the costs of maintaining the household for herself and Braxton. Under these circumstances, what is Anita’s filing status for the current year?

46. Filing Status Example Answer: Head of household

47. Filing Status Example Assume Shawn (Rodney’s brother) lived with the Halls, but Shawn paid more than half the costs of maintaining a separate apartment that is the principal residence of his mother, Sharon, whose gross income is $1,500. Because Shawn provided more than half of Sharon’s support during the year, and because Sharon’s gross income was only $1,500, she qualifies as Shawn’s dependent (as a qualifying relative). In these circumstances, what is Shawn’s filing status?

48. Filing Status Example Answer: Head of household. Shawn paid more than half the costs of maintaining a separate household that is the principal place of abode for his mother, and his mother qualifies as his dependent.