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CHAPTER 1 The Individual Income Tax Return

CHAPTER 1 The Individual Income Tax Return. Income Tax Fundamentals 2010 edition Gerald E. Whittenburg Martha Altus-Buller. History of Taxation. Since 1913 - adoption of 16 th amendment - the constitutionality of income tax has never been questioned

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CHAPTER 1 The Individual Income Tax Return

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  1. CHAPTER 1 The Individual Income Tax Return Income Tax Fundamentals 2010 edition Gerald E. Whittenburg Martha Altus-Buller 2010 Cengage Learning

  2. History of Taxation • Since 1913 - adoption of 16th amendment - the constitutionality of income tax has never been questioned • Income taxes serve a multitude of purposes 2010 Cengage Learning

  3. Objectives of Tax Law • Raise revenue • Tool for social and economic policies • Social policy encourages desirable activities and discourages undesirable activities • Credits for investment in solar and wind energy • Can deduct charitable contributions • Credits for higher education expenses • Economic policy as manifested by fiscal policy • Encourage investment in capital assets through depreciation • Both economic and social • Exclude gain on sale of personal residence up to $250,000 ($500,000 if married) 2010 Cengage Learning

  4. Primary Entities/Forms • Individual • Taxable income includes wages, salary, self-employment earnings, rent, interest and dividends • An individual may file simplest tax form qualified for • 1040EZ • 1040A • 1040 • If error made on one of the three above forms, can amend with a 1040X See next slide 2010 Cengage Learning

  5. Primary Entities/Forms • Individual • 1040EZ • Single or Married Filing Jointly (MFJ) • Must not be 65 or older and/or blind • Must not claim any dependents • Taxable income must be under $100,000 • Only wages, salaries or unemployment and not more than $1,500 taxable interest income • Not received advance earned income credit 2010 Cengage Learning

  6. Primary Entities/Forms • Individual (continued) • 1040A • Generally used by taxpayers who are not self-employed and don’t itemize deductions • 1040 • If taxpayer doesn’t qualify to use 1040EZ or 1040A should complete a 1040 with possible schedules attached: • Schedule A to itemize deductions • Schedule B to report dividends/interest income > $1500 • Schedule C to report trade/business income • Schedule D to report capital gains/losses • Schedule E to report rental/royalty income • Schedule F to report farm/ranch activities 2010 Cengage Learning

  7. Primary Entities/Forms • Corporations • Tax rate schedule found on page 1-3 • 1120 or • 1120S - corporations that elect S Corporation status • Don’t pay regular corporate income taxes • Instead, pass through items of income or loss to shareholders • Partnerships • Reporting entity, not taxable entity • 1065 – reports income/loss and allocation to partners • Pass through items of income or loss to partners 2010 Cengage Learning

  8. Tax Formula for Individuals This formula follows Form 1040 Gross Income less: Deductions for Adjusted Gross Income (AGI) AGI less: Greater of Itemized or Standard Deduction less: Exemptions Taxable Income times: Tax Rate (using tax tables or rate schedules) Gross Tax Liability less: Tax Credits and Prepayments Tax Due or Refund 2010 Cengage Learning

  9. Standard Deductions & Exemptions • 2009 standard deduction • Single $ 5,700 • Married Filing Joint (MFJ) $11,400 • Qualifying Widow(er) $11,400 • also known as Surviving Spouse • Head of Household (HOH) $ 8,350 • Married Filing Separate (MFS) $ 5,700 • *Taxpayers 65 or older and/or blind get an additional amount • $1,100 if MFJ, MFS or SS • $1,400 if HOH or Single • 2009 exemption$3,650 – personal & dependency 2010 Cengage Learning

  10. Using Tax Formula • Facts: Juan (age 29) is a single taxpayer. In 2009, his salary is $39,000 and he has dividend income of $1000. In addition, he has deductions for AGI of $2,500 and $3,000 of itemized deductions. If Juan claims one exemption for this year, calculate the following amounts: • Gross income ___________ • Adjusted gross income ___________ • Greater of the standard • deduction or itemized deductions ___________ • Taxable income ___________ 2010 Cengage Learning

  11. Who Must File • Based on filing status and gross income • Generally, if exemptions plus greater of standard or itemized deductions exceed income, then filing is not necessary • If taxpayer is claimed as a dependent on another’s return, dependent’s standard deduction is: • Greater of $950 or • Earned income + $300 • But never more than standard deduction See Figures 1 and 2 on pages 1-7 and 1-8 2010 Cengage Learning

  12. Who Must File • Taxpayer must file if • Owe any special taxes (See Figure 3 on page 1-8) • Received Advanced Earned Income Credit payments from employer • Had self-employment (SE) income >= $400 • Other situations outlined on Chart C 2010 Cengage Learning

  13. Which Taxpayers are Required to File Note: Must analyze each independent situation to determine if the taxpayers are required to file a return for 2009 Miles (age 45) is a single waiter and has unreported tips of $1,510; is he required to file? Yes, because taxpayer owes social security taxes on unreported tips. 2010 Cengage Learning

  14. Which Taxpayers are Required to File Taxpayer is single (age 31) and blind and has income of $9,950; is the taxpayer required to file? No, because standard deduction = $7,100 ($5,700 + 1,400); exemption= $3,650. These amounts total to $10,750 and exceed income. 2010 Cengage Learning

  15. Which Taxpayers are Required to File Husband (age 67) and wife (age 69) have income of $19,180 and MFJ; are the taxpayers required to file? No, because standard deduction = $13,700 ($11,400 + 1,100 + 1,100); exemptions = $7,300. These amounts total to $20,900 and exceed income. 2010 Cengage Learning

  16. Which Taxpayers are Required to File Taxpayer is a single full time college student, age 21, with wages from a part-time job of $6,340. He is claimed as a dependent by his parents; is the taxpayer required to file? Yes, because standard deduction = $5,700; exemption = 0 (as he’s claimed by parents). Income exceeds these amounts. 2010 Cengage Learning

  17. Filing Status • Single • Unmarried or legally separated as of 12/31 • And not qualified as married filing separately, head of household or qualifying widow(er) • Married Filing Jointly (MFJ) • If married on 12/31 – even if didn’t live together entire year • Same-sex couples may not file jointly • If spouse dies during year you can file MFJ in current year • Married Filing Separately (MFS) • Each file separate returns • Must compute taxes the same way - both itemize or both use standard • If living in community property state, must follow state law to determine community and separate income 2010 Cengage Learning

  18. Filing Status *See p. 1-10 for requirement for abandoned spouse • Head of Household (HOH) • Tables have lower rates than single or MFS • Taxpayer can file as HOH if: • Unmarried or abandoned* as of 12/31 • Paid > 50% of cost of keeping up home that was principal residence of dependent child or other qualifying dependent relative • There is one exception to principal residence requirement:if dependent is taxpayer’s parent, he/she doesn’t have to live with taxpayer Note: A divorced parent who meets above rules and has signed IRS/legal document, may still claim HOH even if dependency exemption shifted to ex-spouse 2010 Cengage Learning

  19. Filing Status • Qualifying Widow(er) with Dependent Child • Also known as surviving spouse • Available for two subsequent years after death of spouse • Must pay over half the cost of maintaining a household where a dependent child, stepchild, adopted child or foster child lives • Gets benefits of married filing joint tax rates 2010 Cengage Learning

  20. Tax Computation • Six brackets (in Appendix) • 10%, 15%, 25%, 28%, 33%, 35% • Tax rate schedules for different filing types • Marginal rate may exceed 35% when taxpayers are required to phase-out exemptions and deductions • Qualifying dividends and net long-term capital gains may be taxed at lower rates • Rates based on ordinary tax bracket 2010 Cengage Learning

  21. American Recovery & Reinvestment Act (ARRA) • Provisions includes Making Work Pay Credit • $400 ($800 MFJ) refundable credit on 2009 tax return • Reduced by any automatic rebate received by certain taxpayers in 2009 • Reflected in new FIT withholding tables which directly infused cash into economy through increased wages • Phases-out $75,000 ($150,000 MFJ) • Complete Schedule M to calculate credit 2010 Cengage Learning

  22. Personal/Dependency Exemptions • Personal exemptions may be taken for self/spouse • Additional exemptions may be taken for individuals who are either • Qualifying child or • Qualifying relative • For 2009 each exemption = $3,650 • Exemption phased-out to $2,433 when AGI exceeds certain AGI thresholds 2010 Cengage Learning

  23. Dependency – Qualifying Child Dependency exemption allowed for child when six tests met • Relationship Test - child is taxpayer’s child, stepchild, adopted child or taxpayer’s sibling, half- or step-sibling, or a descendant of any of these. Foster child may also qualify. Child must be younger than person claiming him/her, unless permanently disabled. • DomicileTest- child has same principal place of abode as taxpayer for more than ½ the year. • Age Test– child is under 19 or a full-time student under 24 (enrolled at least 5 months of year). 2010 Cengage Learning

  24. Dependency – Qualifying Child • Joint Return Test – child doesn’t file joint return with spouse (exception: if it’s only to claim refund, then considered to have passed this test). • Citizenship Test – child is a US citizen, a resident of the US, Canada or Mexico, or an alien child adopted by and living with a US citizen. • Self-Support Test – child who provides more than ½ of his/her own support cannot be claimed as a dependent of someone else. Funds received by students as scholarships are excluded from support test. 2010 Cengage Learning

  25. Dependency – Qualifying Relative Dependency exemption may be granted for a qualifying relative (who is not a qualifying child). Note: A taxpayer’s child who does not meet qualifying child test may meet qualifying relative test!! 2010 Cengage Learning

  26. Dependency – Qualifying Relative • Relationship or Member of Household Test – list of relatives that qualify is available at IRS web site Note: A member of household (even if unrelated) for entire year meets the relationship test • Gross Income Test – individual may not have gross income in excess of $3,650 • Support Test – dependent must receive over ½ of his/her support from taxpayer • Joint Return Test – dependent may not file a joint return unless it’s solely to claim refund • Citizenship Test – dependent must meet the citizenship test identified in the qualifying child slide 2010 Cengage Learning

  27. Standard Deduction • 2009 standard deduction • Single $ 5,700 • Married Filing Joint (MFJ) $11,400 • Qualifying Widow(er) $11,400 • also known as Surviving Spouse • Head of Household (HOH) $ 8,350 • Married Filing Separate (MFS) $ 5,700 • *Plus additional amounts for blindness or over 65: $1,100 if MFJ, MFS or qualifying widow(er) and $1,400 if HOH or Single • For 2009 only, may add sales tax on qualified motor vehicle purchased after 2/16/09 and lesser of $500 (or $1,000 MFJ) or actual real estate taxes paid to standard deduction 2010 Cengage Learning

  28. Standard Deduction - Dependents The special rule for standard deduction for dependents is “deduction = greater of $950 or earned income + $300 but only up to basic standard deduction” Example 1: Jaime is 23 and a full time student and her parents claim her as a dependent; she earned $2,000 in 2009. $2,000 earned income (2,000) standard deduction $0 taxable income Example 2: Tia is 18 and has dividend income of $1,500 (not earned) $1,500 dividend income ( 950) standard deduction $ 550 taxable income 2010 Cengage Learning

  29. Gains and Losses Basic Gain/Loss Model Amount Realized* - Adjusted Basis** Realized Gain/Loss *Sales Price - Sales Expenses **Cost - Accumulated Depreciation 2010 Cengage Learning

  30. Capital Gains/Losses • A capital asset is any property (personal or investment) held by a taxpayer, with certain exceptions as listed in the tax law • Examples: stocks, bonds, land, cars and other items held for investment • Gains/losses on these assets are subject to special rates • Holding period of asset determines treatment • Long-term is held >12 months (taxed at capital rates – see next screen) • Short-term is held <= 12 months (taxed at ordinary rates) 2010 Cengage Learning

  31. Capital Gains/Losses • Long term capital gain • Special rates depending upon taxpayer’s bracket Ordinary Tax Bracket Capital Gains Tax Rate 10% or 15% 0% All other brackets 15% • Long term capital loss • Only allowed $3,000 net capital loss per year against ordinary income • Carry-forward any unused balance 2010 Cengage Learning

  32. Calculating Gain/Loss Facts: Noah purchased Sony AAA bonds in 2001 for $47,600. In 2009, he sold the bonds for $51,500, paying commission of $515. What is his: Amount realized ___________ Adjusted basis ___________ Realized gain/loss ___________ Recognized gain/loss ___________ Type of gain/loss ___________ 2010 Cengage Learning

  33. The End! 2010 Cengage Learning

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