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

 Since adoption of 16 th amendment - the constitutionality of income tax has never been questioned  Income taxes serve a multitude of purposes 2010 Cengage Learning2

 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 Learning3

 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 2010 Cengage Learning4 See next slide

 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 Learning5

 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 Learning6

 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 Learning7

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 Learning8

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 Learning10 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___________

 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 Cengage Learning11

 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 Learning12

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 Cengage Learning13

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, ,400); exemption= $3,650. These amounts total to $10,750 and exceed income Cengage Learning14

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, , ,100); exemptions = $7,300. These amounts total to $20,900 and exceed income Cengage Learning15

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 Cengage Learning16

 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 Learning17

 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 Learning18 *See p for requirement for abandoned spouse

 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 Learning19

 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 Learning20

 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 Learning21

 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 Learning22

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. ·Domicile Test- 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) Cengage Learning23

¹ 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). º 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 Cengage Learning24

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 Learning25

¶ 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 ¹ Joint Return Test – dependent may not file a joint return unless it’s solely to claim refund º Citizenship Test – dependent must meet the citizenship test identified in the qualifying child slide 2010 Cengage Learning26

2010 Cengage Learning 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 Learning28 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 $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 Learning29 Basic Gain/Loss Model Amount Realized* - Adjusted Basis** Realized Gain/Loss *Sales Price - Sales Expenses **Cost - Accumulated Depreciation

 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 Learning30

 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 Learning31

2010 Cengage Learning32 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 Learning33