Individual Income Tax Computation and Tax Credits Chapter 7 Individual Income Tax Computation and Tax Credits © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part. 

Learning Objectives Determine a taxpayer’s regular tax liability and identify tax issues associated with the process. Compute a taxpayer’s alternative minimum tax liability and describe the tax characteristics of taxpayers most likely to owe the alternative minimum tax. Calculate a taxpayer’s employment and self-employment taxes payable and explain tax considerations relating to whether a taxpayer is considered to be an employee or a self-employed independent contractor.

Learning Objectives (cont’d) Describe the different general types of tax credits, identify specific tax credits, and compute a taxpayer’s allowable child tax credit, child and dependent care credit, earned income credit, American opportunity credit, lifetime learning credit, and earned income credit. Explain taxpayer filing and tax payment requirements and describe in general terms how to compute a taxpayer’s underpayment, late filing, and late payment penalties.

Federal Income Tax Computation Regular tax computation dependent upon: Filing status Married filing jointly Qualifying widow or widower (also called Surviving spouse) Married filing separately Head of household Single Progressive tax rates Tax rate schedules Tax tables

Federal Income Tax Computation Tax brackets or marginal tax rates on ordinary income 10%, 15%, 25%, 28%, 33%, 35%, and 39.6% Marriage penalty or benefit Who is likely to have penalty? Both spouses receive income Who is likely to have benefit? One spouse receives income

Federal Income Tax Computation Exceptions to ordinary tax rates Long-term capital gains (net capital gains) Generally 0%,15%, or 20%, but can be as high as 28% Two different tax rates on one gain is possible Dividends Qualified dividends generally taxed at 0%,15%, or 20% Two different tax rates on one dividend is possible

Alternative Minimum Tax Items commonly added back to regular taxable income in computing AMT income Personal and dependency exemptions State income taxes Real property taxes Home-equity loan interest expense (if proceeds not used to improve home) Miscellaneous itemized deductions in excess of 2% floor

Alternative Minimum Tax AMT is a tax based on an alternative more inclusive tax base than regular taxable income. Meant to ensure that taxpayers are paying some minimum level of tax. Who is most likely to pay it and why? High state taxes Multiple children Capital gains

Alternative Minimum Tax Why is it becoming so prevalent? Exemption phase-out threshold not indexed for inflation Individual tax rates have decreased since AMT enacted AMT rates 26% or 28% vs. individual ordinary rates 10%, 15%, 25%, 28%, 33%, 35%, 39.6%

Employment FICA Taxes Employee Employer Must pay FICA taxes on compensation from employer (6.2 % Social Security tax rate; 1.45% to 2.35% Medicare tax rate) $113,700 limit applies to Social Security portion Multiple employers during year Employer Pays FICA tax on employee’s compensation (6.2% Social Security tax rate; 1.45% Medicare tax rate) & withholds FICA tax from employee’s pay check

Employment and Self-Employment Taxes Self-employed taxpayers Responsible for entire FICA tax (employee and employer share) Tax base is net earnings from self-employment (net Schedule C income (generally) and multiply by .9235) Same $113,700 limit applies to Social Security portion

Employment and Self-Employment Taxes If net earnings from self-employment < $400, no SE tax. How does $113,700 Social Security earnings limit apply when have both wages and SE earnings in the same year? Wages use up limit first– taxpayer favorable or unfavorable? Why?

Employee vs. Independent Contractor Determining whether taxpayer is employee or independent contractor Primary question: who has control over how, when, where work is performed? Tax differences Amount of FICA or SE taxes payable Deductibility of expenses For AGI From AGI Employer portion of self-employment taxes

Tax Credits Reduce tax liability dollar for dollar Consist of three categories Nonrefundable personal Refundable personal Business

Nonrefundable Personal Child tax credit $1,000 for each qualifying child under age 17 at end of year Partially refundable in certain situations Phase-out amount not percentage Child and Dependent care credit Dependent under age of 13 (or disabled dependent) Percentage of qualifying expenditures Maximum qualifying expenditures: $3,000 one qualifying person, $6,000 two or more qualifying persons Percentage depends on AGI (see Exhibit 7-9)

Nonrefundable Personal American opportunity credit (formerly Hope scholarship credit) For first four years of post-secondary education For eligible expenses and institutions only Applied per student Taxpayer, spouse, taxpayer’s dependents Amounts paid by dependents treated as paid by taxpayer 100% of first $2,000 of eligible expenses and 25% of next $2,000 (maximum credit is $2,500) Phase-out based on AGI 40% of credit is refundable

Nonrefundable Personal Lifetime learning credit Eligible expenses (tuition) for post-secondary education Includes professional or graduate school Includes continuing education Applied per taxpayer MFJ return is one taxpayer 20% of up to $10,000 of eligible expenses Phase-out based on AGI

Nonrefundable Personal Education credits If deduct for AGI educational expenses for someone, no education credit allowed for that person Could take American opportunity credit for one dependent and for AGI deduction for another

Refundable Personal Earned income credit Negative income tax Must have earned income Must have at least one qualifying child or must be at least 25 years old and less than 65 and not a dependent of another See Exhibit 7-10

Tax Credits Business credits Promote certain behaviors If credit exceeds tax, carry back one year and carry forward 20 years Foreign tax credit Hybrid business and personal – nonrefundable; carry back one year and carry forward 10 years

Prepayments and Filing Requirements Taxes must be paid-as-you-go Withholdings Treated as made equally throughout the year Estimated tax payments Due on April 15th, June 15th, September 15th, and January 15th of the following year

Prepayments and Filing Requirements Underpayment penalties Safe-harbor requirements 90% of current tax liability or 100% of previous year’s tax liability (110% with higher AGI > $150,000) – 25% at each estimated filing deadline

Prepayments and Filing Requirements Underpayment penalties Applied on quarterly basis 90%/4 = 22.5% of current year liability must be paid in by deadline or 100%/4 = 25% of previous year’s liability must be paid in by deadline Penalty based on amount of underpayment at each quarter x federal short term rate + 3%

Prepayments and Filing Requirements Generally, must file if gross income > standard deduction + personal exemption amounts If married filing separately must file if gross income > personal exemption amount Lower thresholds for those claimed as dependent on another’s tax return Due dates April 15th Extend filing up to six months May not extend due date for paying taxes

Prepayments and Filing Requirements Late filing penalty 5% of tax owed per month up to 25% if not fraudulent; 15% of tax owed per month up to 75% if fraudulent No penalty if no tax is due Late payment penalty If don’t pay entire tax owed by due date of return .5% of amount due up to 25% maximum if not fraudulent 15% of amount due per month up to 75% if fraudulent Combined late filing and late payment penalties may not exceed maximum amounts for either one