Chapter 4

Individual Tax Overview

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Learning Objectives
1.

2.

3.

Describe the formula for calculating an individuals tax liability and generally explain each formula component. Explain the requirements for determining a taxpayers personal and dependency exemptions. Determine a taxpayers filing status.

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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

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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)
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Individual Income Tax Formula

Individuals report taxable income to the IRS

Reported on Form 1040

U.S. tax laws use all-inclusive gross 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

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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

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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 (current year tax rate is zero) 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 longterm, otherwise it is short-term
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Individual Income Tax Formula

Capital assets

Generally all assets except

Accounts receivable Inventory Assets used in trade or business, including supplies

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Individual Income Tax Formula

Capital gains and losses

Long-term capital gains generally taxed at 0%, 15%, or 20% depending on the taxpayers 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

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Individual Income Tax Formula

Deductions for AGI

Deductions above the line Deducted in determining adjusted gross income Always reduce taxable income dollar for dollar

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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?

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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)

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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.

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Individual Income Tax Formula

Other taxes include:

Alternative minimum tax Self-employment taxes Medicare Contribution tax on net-investment income Reduce tax liability dollar for dollar

Tax credits

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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 years liability

If prepayments exceed tax liability after credits, taxpayer receives a refund

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Personal and Dependency Exemptions

Personal exemptions

For taxpayer and spouse if married filing jointly For those who qualify as the taxpayers dependents

Dependency exemptions

Exemption amount for 2013 is $3,900

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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

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Personal and Dependency Exemptions

Qualifying child

Relationship test Age test Residence test Support test

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Qualifying Child

Relationship test

taxpayers son, daughter, stepchild, an eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister or a descendant of any of these relatives.

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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 fulltime student, or permanently and totally disabled.

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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

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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?

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Qualifying Child Example Solution

Test Relationship Braxton Yes, son Tara Yes, daughter

Age

Yes, < 19 at year-end (and younger than his parents)

Yes, lived at home entire year Yes, he provides <

Yes, < 24 at year-end and full-time student (and younger than his parents)
Yes, temporary absences such as school ok Yes, parents provide > (scholarship does not count as self support)
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Residence

Support

Qualifying Child

Tie breaking rules

Parents first Days living with each parent if parents living apart AGI higher AGI gets exemption

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Qualifying Child Example

Braxtons uncle Shawn (Rodneys brother) lived in the Hallss home (the same home Braxton lived in) for more than 11 months during 2013. Does Braxton meet the requirements to be considered Shawns qualifying child?

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Qualifying Child Example Solution

Test Is Braxton Shawns qualifying child?

Relationship
Age Residence Support

Yes, son of Shawns brother

Yes, < 19 at year-end (and younger than Shawn) Yes, lived in the same residence as Shawn for more than half the year Yes, does not provide more than half of own support

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

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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 Braxtons parents.

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Personal and Dependency Exemptions

Qualifying relative

Relationship test Support test Gross income test

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Qualifying Relative

Relationship test

a descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent), a sibling of the taxpayer including a stepbrother or stepsister a son or daughter of the taxpayers brother or sister (not cousins) a sibling of the taxpayers mother or father in-law (mother-in law, father-in-law, sister-in-law, and brother-in-law) of the taxpayer, or unrelated person who lives in taxpayers home entire year
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Qualifying Relative

Support test

Taxpayer must pay > of living expenses (support)

Scholarships of actual child excluded

Gross income test

Gross income < personal exemption amount

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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 Johns parents able to claim him as a dependent?
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Dependency Exemption Example Solution

Test Relationship Age Residence Support Gross income Qualifying child Yes, child Qualifying relative Yes, child

Yes, < 24 and full-time Not applicable student Yes, temporary absences ok Yes, he provides < Not applicable Not applicable Yes, parents provide > No, gross income > $3,900
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Personal and Dependency Exemptions

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Filing Status

Five different filing statuses

Married filing jointly Married filing separately Qualifying widow or widower (surviving spouse) Single Head of household

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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

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Filing Status

Married filing separately

Taxpayers are married but file separate returns

Typically not beneficial from tax perspective

Tax rates and other tax benefits No joint and several liability

May be beneficial for non-tax reasons

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Filing Status

Qualifying widow or widower

Available for the two years following the year of spouses death Surviving spouse does not qualify if remarries during two-year period. Surviving spouse must maintain household for dependent child

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Filing Status

Single

Unmarried unless qualify for head of household

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Filing Status

Head of household

Unmarried or considered unmarried at end of year

See discussion of married individuals treated as unmarried (abandoned spouses) below

Not a qualifying widow or widower Pay more than half the costs of keeping up a home during the year Lived in taxpayers home with a qualifying person for more than half of the year

Exception for parents (see below)

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Filing Status

Qualifying person

Qualifying child Qualifying relative who is taxpayers mother or father

Parent need not live with taxpayer Taxpayer must pay > cost of maintaining separate household for taxpayers mother or father Parent must qualify as taxpayers dependent

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Filing Status

Qualifying relative who is not the taxpayers parent

Person must have lived with taxpayer for more than half the year Must qualify as taxpayers dependent Must be related to taxpayer through qualified family relationship

If related only because lived with taxpayer for entire year, not a qualified person.

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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 > 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)

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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 Anitas filing status be?

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Filing Status Example

Answer: Qualifying widow

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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 Anitas filing status for the current year?

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Filing Status Example

Answer: Head of household

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Filing Status Example

Assume Shawn (Rodneys 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 Sharons support during the year, and because Sharons gross income was only $1,500, she qualifies as Shawns dependent (as a qualifying relative). In these circumstances, what is Shawns filing status?

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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.

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