1. The Individual Tax Model
Chapter 14
The Individual Tax Model

2. Filing Status - Married
If married on the last day of the year: status must be either Married filing joint or Married filing separately.
MFJ rates apply to Surviving Spouse
widow or widower with a dependent child for two more years after death of spouse.
MFS (married filing separately) rates are less favorable than single.
Generally only used for separated couples or US citizens or residents married to a nonresident alien

3. Filing Status - Unmarried
Single is the default category for unmarried individuals (neither surviving spouse nor head of household).
Head of household - maintain a home for either
child (need not be dependent)
dependent relative

4. Taxable Income Computation
Calculate total income totaling Line 22 on 1040.
Calculate Adjusted Gross Income (AGI) on Line 37 of 1040.
Subtract the greater of:
itemized deductions or
the standard deduction
Subtract total exemptions
Result is Taxable Income

5. Individual Tax Model – Gross Income / Exclusions
General Rule: Gross Income is “Broadly Conceived”: Includes all income subject to taxation unless specifically indicated as not taxable by law.
Exclusions include:
unrealized gains, gifts, inheritances, welfare type payments, many fringe benefits, returns of capital, Municipal Interest, some US Govt for higher education, life insurance proceeds.
Scholarships - excludible if
recipient is candidate for degree, amount received is not a payment for services, and is used to pay tuition, books, and other similar educational expenses
Foreign earned Income (Sec. 911) - build U.S. Economy
Exclude up to $101,300 of foreign earned income annually plus a housing allowance (exclusion cannot exceed earned income
Individual must be a bona fide resident of the foreign country for an entire tax year or be in the foreign country for 11 mos in any 12 month period.

6. Individual Tax Model: Special Income Inclusions
Annuities: Amount not taxed: Inv. / Expected Return * Pymts Rec
Deferred Compensation Plans: Defined Contribution Plans, Defined Benefit Plans - Qualified Retirement Plans
Prizes and Awards - include FMV
Social Security Benefits - up 85% may be taxed
Unemployment compensation is taxable
Alimony received is taxable / Child support is not includible but is not deductible either.

7. Special Rules
Dividends (cash and noncash) - FMV of prop received (subject to E& P provisions)
Stock dividends generally not taxable
Damages - personal (special rules) business damages not excludible.
Discharge of indebtedness - generally includible.

8. Business versus Investment
Business activity
Time and talent on regular basis
Profit partially attributable to personal involvement
Income is considered earned income
Hobby losses only deductible to extent of hobby income – not a business activity
Investment activity
Passive role as owner of income-producing property
Income is considered unearned income
Losses on personal use assets are not deductible – gains from sale are treated as capital assets.

9. Investments in Financial Assets
Securities include:
common and preferred stock
savings accounts, CDs, notes, bonds
Return on / Income from investment includes
Interest (ordinary income)
Dividends (special rules post May 2003)
Reinvested dividends are still taxable but increase basis.
gains (losses).
Mutual funds may report ‘distributed’ capital gains/losses. These are still taxable but increase basis even if no cash received. 3

10. Gains/Losses on Securities
Realization requires a sale or exchange
Gain/loss = Proceeds - adjusted basis
Character is capital - time period matters
Basis issues
reinvested dividends increase basis.
Sale of stock uses either specific ID or FIFO method of matching basis with sales.
Mutual fund shares sold typically use an average basis. 7

11. What to do with Capital Gains and Losses
SHORT TERM asset held for <= 1 year – gains taxed as ordinary income
LONG TERM asset held for > 1 year
L/T Gains taxed at lower capital gains rates of 0,15,20%
Net the gains and losses in each class (net ST, net LT, net 28%LT).
Special rule for sale of principal residence
Exclude gain up to the amount of statutory exclusion if home is principal residence 2 years out of 5 years ending on date of sale.
Exclude only one gain every 2 years.
Limits $500,000 MFJ, $250,000 other 10

12. Deductions for Adjusted Gross Income and AGI
Trade/Business Exp from a Sole Proprietorship are reported on Schedule C / or for a rental property are recorded on schedule E
Student Loan interest up to $2500 (Income limits apply)
Self Employed Expenses: 50% of SE tax, percentage of health insurance premiums, Keogh and Simple retirement plans
IRAs, Moving Expenses, Contributions to MSAs
Penalty for early withdrawal of savings
Result of Income less deductions for Adjusted Gross Income –is AGI (very key concept) - many deductions are a function of AGI (e.g., IRA deductions, medical expenses, charitable contributions)
Many items of gross income are also a function of AGI
Social Security Benefits, Passive Activity Losses

13. Deductions from AGI: Standard Deduction or Itemized Deductions
Standard Deduction Depends on filing status. For 2016/15:
MFJ = $12,600/$12,600
MFS = $6,300/$6,300
HOH = $9,300 / $9,250
Single = $6,300/$6,300
Blind or aged (>=age 65)
MJF, MFS = additional $1,200/$1,250
HOH or Single = additional $1,550
Take the higher of Standard Deduction or Itemized Deductions as a reduction of AGI in the computation of Taxable Income – Discussion of Itemized Deductions follows

14. Itemized Deductions / Personal Losses - Chapter 17
a special class of deductions that allow taxpayers to derive tax benefits from certain personal & investment expenditures
Individuals deduct the greater of the standard deduction for his/her filing status or the total of his/her itemized deductions.
About 1/3 of all TPs claim itemized deductions
Itemized deductions are shown on Form 1040 Schedule A.

15. Medical Expense Deduction
Sec qualified non-reimbursed medical expenses for a TP and dependents qualify for a deduction subject to a 10% of AGI floor (7.5% if over 65) - only 5% of TPs benefit
Qualifying expenses include
Medical insurance premiums / prescription drugs
Medical treatment / Physical & Psychological treatment
medical products, glasses, artificial limbs etc.
Capital improvements - limited to excess over increase in home value due to the improvements.
Capital improvements to remove structural barriers for physically handicapped - fully deductible.
Cosmetic surgery if it results from disease, personal injury or congenital defects.
No deduction allowed for:
Elective cosmetic surgery

16. Taxes Sec 164 - lists deductible taxes
In general - only income taxes (other than Federal) and property taxes -ad valorem taxes on investment and personal property are deductible.
Taxes must be distinguished from assessments, fines & penalties which are not deductible.
Taxes are only deductible when they are the taxpayers obligations. No deduction for paying another persons taxes. No deduction is someone else pays your taxes.
50% of SE tax is deductible,
Sales tax are deductible if total is greater than income taxes paid to a particular state.

17. Interest
Sec certain types of interest paid or accrued by a taxpayer during the year is deductible
Mortgage interest, some points, home equity interest or investment interest - are individual itemized deductions
Investment interest expense- deductible to extent of net investment income ( Gross Inv. Inc - Inv. Exp.)
Inv. Interest deduction not allowed if used to purchase tax exempt securities.
Qualified Residence Interest
indebtedness used to purchase, construct or improve the taxpayers residence
2 homes allowed -Int on debt up to $1 Million is ded..
Home equity interest limited to principal of 100K
Point on new loan or improvement loan deductible when paid. Refinancing - amortized over loan life.

18. Charitable Contributions
Sec gifts to qualified charities is deductible
Qualified charities: U.S. based organizations operated exclusively for religious, charitable, scientific, literary or educational purposes or for the prevention of cruelty to children or animals.
Contribution amount
reduced by value of any benefit received by the donor
LTCG property = value is FMV
No deduction allowed for contribution of services or rent free use of property.
Contribution Limits
LTCG property - limited to 30% of AGI
Total contributions limited to 50% of AGI
Excess contributions can be carried forward 5 years
If contributing property, TP must be able to substantiate value.
Must file form 8283 if noncash contributions > 500
Independent appraisal is required when a single item of donated property is valued in excess of $5,000.

19. Casualty Losses / Miscellaneous Itemized Deductions
Casualty losses - unreimbursed losses due to theft or casualty. Losses are reduced by $100 and 10% of AGI. Excess, if any is deductible as an itemized deduction.
Misc. deductions subject to 2% of AGI limitation- (must exceed 2% of AGI to be deductible)
Unreimbursed Employee Business Expenses - union dues, uniforms, business use of auto, job search, other prof. Dues
Expenses for managing or safeguarding assets: safe deposit rental, investment advice, investment publications
Tax determination expenses: Tax prep fees, legal representation in tax audit, legal and accounting fees for tax planning, appraisals for tax reporting
Misc. deductions not subject to 2% limitation
gambling losses to extent of gambling winnings
unrecovered investments in annuities due to annuitants death.

20. Exemptions Personal exemption for the taxpayer (2 for MFJ).
If you are a dependent on someone else’s return, can you still claim yourself?
Exemption = $4,050/$4,000 in 2016/15 for each personal or dependency exemption.

21. Exemptions for Dependents
Family member OR live in your home for entire year.
You provide > 1/2 financial support
Dependent’s gross income < exemption amount ($4,000 for 15)
waived for child < 19 OR student-child<24
Dependent may not generally file a joint return.
Dependent must be a U.S. citizen OR a resident of US, Mex, Canada

22. Rich People
Phase-out of itemized deductions –Haircut (reduction in allowed itemized deductions) = AGI – Threshold ($311,300/ $309/900 (2016/15) for MFJ) * 3%.
Phase-out of exemptions – Repealed in Returned effective 1/1/ For our class assume if AGI is greater than $440,000 then no personal exemptions are allowed. If AGI < $440,000 allow full amount of exemptions.
Tax on net investment income (dividends, interest, capital gains, net income on passive activities): 3.8% for individuals with income in excess of $200,000, MFJ in excess of $250, Please know it exists but we will not compute the tax on our assignments for this course.

23. Tax Credits
A credit is a dollar for dollar reduction in the tax liability. A deduction only reduces the tax by the marginal tax rate associated with that deduction.
Child Credit = $1,000 per child in Phases out for rich.
Dependent care credit (child < 13 years old). Credit amount between 30% and 20% of child care costs depending on income range.
Earned income credit. This is refundable - a transfer payment to working poor. Increases progressivity of tax rates. Credit is higher for taxpayers with children and phases out as income increases.
Excess FICA withholding is refunded through a tax return claim.

24. Tax Subsidies for Education
Hope scholarship credit / American job opportunity cred - 1st 4 years of college. Max $2500 per year per student based on tuition/fees. Phase out for MFJ between $ K)
Lifetime learning credit = 20% of tuition/fees: Max $5000 per year. Lifetime credit phase out begins $ K for MFJ
Education IRA - withdrawals spend on education are tax-free.

25. Payment and Filing Requirements
Taxes on wages are withheld each pay period.
Estimated taxes are due on April 15, June 15, September 15, and January 15.
Pay 90% of current year tax, 100% of prior year (or 110% of prior year AGI>$150,000).
Tax return due 4/15, but may be extended to 10/15 (LAST DATE).

26. Kiddie Tax
Children under age 18 with unearned income greater than $2,000 are subject to kiddie tax
The unearned income in excess of $2,100 is taxed at the parent’s highest marginal tax rate
The residual taxable income is taxed at the child’s rate.
What are the kiddie tax provisions designed to prevent?

27. Wealth Transfer Tax System – Covered on last day of class.
This is an excise tax system which is different from the income tax system.
Gift, estate, and generation skipping transfer taxes
The unified gift and estate tax is based on cumulative transfers over time (life + death).
Current tax rate is 40% 19 19 19

28. Gift Tax
Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation.
Exclude $14,000 per year per donee from taxable gifts.
No gift tax on gifts to spouse, charity, paying tuition or medical costs.
Can treat gift by one spouse as made 1/2 by other spouse. 20

29. Exclusion
Lifetime exclusion
$5,450,000 21

30. Income Tax Effects of Gifts
Gift is not taxable income to donee.
Donor’s adjusted basis in the property carries over to become the donor’s basis.
exception - use FMV if less than adjusted basis
After gift, any income derived from the property belongs to the donee. 22

31. Estate Tax Taxed at unified estate and gift rate schedule
FMV of estate is taxed
Unlimited marital deduction
Reduce estate by taxes, charity, administrative expenses. 24

32. Income Tax Effect of Bequests
Receipt of a bequest is not taxable income to heir.
Basis = FMV at date of death = free income tax step-up in basis. (In 2010, wealthy estates generate carryover basis).
Trade-off -
gift now at low basis, perhaps avoid some transfer tax
keep and include in estate, but heirs get high basis 25