1. Income Taxation of Individuals
Chapter 11
Income Taxation of Individuals

2. Individual Income Tax Model
Gross income
Less: Deductions for adjusted gross income
Equals: Adjusted Gross Income (AGI)
Less: Itemized or standard deduction
Less: Personal & dependency exemptions
Equals: Taxable income

3. Tax Model (continued) Taxable income Times: Tax rate
Equals: Gross income tax liability
Less: Tax credits
Plus: Additions to tax
Less: Tax prepayments
Equals: Net tax due or tax refund

4. Deductions For AGI Deductions discussed in previous chapters
Retirement plan contributions including IRAs
Moving expenses
50% of self-employment taxes
Self-employed health insurance
Alimony paid

5. Deductions For AGI Deductions discussed in this chapter
Educator expenses
Student loan interest expense
Tuition and fees deduction
Health savings accounts
Penalty on early withdrawals of savings
Other deductions for AGI

6. Educator Expenses
Kindergarten through 12th grade teachers may deduct up to $250 of unreimbursed expenses for books, supplies, computer equipment, software, and other supplemental materials used in the classroom
Due to expire at end of 2005 unless extended by Congress

7. Student Loan Interest
Deduction allowed for interest paid on qualified student loans incurred and used for tuition, fees, room, board, books, and supplies
Deduction limit is $2,500
Limit is phased out for modified AGI of $50,000 - $65,000 ($105,000 - $135,000 for married persons filing jointly)
Individuals claimed as dependents cannot take deduction on their own tax return
Eligible expenses must be reduced for tax-exempt scholarships and education credits

8. Tuition & Fees Deduction
$4,000 deduction for for tuition & fees for taxpayer, spouse, and dependents
Income limits apply ($65,000 if single and $130,000 if married filing jointly)
Deduction is reduced to $2,000 for singles with income $65,000 - $80,000 ($130,000 - $160,000 for joint filers)
Individuals who are claimed as dependents cannot take deduction on their own tax return
No double benefit - no deduction if expense is deductible under any other provision (including education credits)

9. Health Savings Accounts
Taxpayers covered by high-deductible medical insurance policies only may deduct amounts set aside in an HSA
Contributions and earnings on HSAs are not taxed when withdrawn to pay medical expenses
Distributions not spent on qualifying expenses are included in income and subject to a 10% penalty

10. Health Savings Accounts
To qualify for an HSA in 2005, individuals must have health insurance with deductibles of at least $1,000 ($2,000 for families)
Maximum contribution to HSA equal to lesser of $2,650 ($5,250 for families) or the annual policy deductible

11. Medical Savings Accounts
MSAs are similar to HSAs but with different limits
Qualified policies are those with deductibles of $1,750 - $2,650 for individuals ($3,500 - $5,250 for families) in 2005
Contributions to MSAs are limited to 65% of policy deductible for individuals (75% for families)
Distributions not spent on qualifying expenses are included in income and subject to a 15% penalty

12. Penalty on Early Withdrawals
Penalties assessed on premature withdrawals from certificates of deposits or other savings accounts are deductible
Gross interest income, unreduced by the penalty, is included in taxable income
Deducting the penalty ensures that only net interest income is included in taxable income

13. Other Deductions For AGI
Unreimbursed travel expenses to attend National Guard or military reserve meetings more than 100 miles from home
Maximum deduction is general government per diem rate for the area
Expenses of fee-basis government officials
Expenses of performing artists

14. Exemptions
Each taxpayer (who is not a dependent) is entitled to one personal exemption
Exemption deduction is $3,200 for 2005
Additional exemptions allowed for each person who is considered a dependent
Anyone who is claimed as a dependent cannot claim a personal exemption
For purposes of the dependency exemption, a dependent is a qualifying child or qualifying relative

15. Qualifying Child Must meet four tests
Residency test - live with taxpayer more than 6 months
Relationship test - son, daughter, brother, sister, or descendant
Age test - under 19 (or under 24 if full-time student)
Support test - child cannot provide more than half his own support

16. Qualifying Relative
If not a qualifying child, then three similar tests must be met:
Relationship test - must either be a qualifying relative of the taxpayer or a resident in the taxpayer’s household for the entire year
Gross income test - the qualifying relative's gross income from taxable sources must be less than the exemption amount ($3,200 for 2005)
Support test

17. The Support Test
Taxpayer must provide more than 50% of the dependent's total support
Support includes amounts spent for food, clothing, shelter, medical care, education and capital expenditures such as a car
Value of services and scholarship funds are omitted in determining support received by a student
Dependent’s nontaxable income used for support must be included in support determination

18. Multiple Support Agreement
Multiple support agreements allow one member of group of support providers to claim the exemption when
Together the group meets the support test
All other dependency tests are met
Member who claims exemption must provide more than 10% of the total support and other members providing more than 10% support agree to exemption

19. Phaseout of Exemptions
Both personal and dependency exemptions are phased out at a rate of 2% (4% for MFS) for each $2,500 (or fraction thereof) of AGI above thresholds for 2005 of
$145,950 if single
$182,450 if head of household
$218,950 if married filing jointly
$109,475 if married filing separately

20. Exemption Phaseout
(AGI – threshold AGI)/$2,500 = Phaseout Factor (always round up to next whole number)
Phaseout Factor x 2% = Phaseout Percentage
Exemption Amount x (1 – Phaseout Percentage) = Adjusted Exemption Deduction
Once AGI exceeds the threshold AGI by more than $122,500 ($61,250 for MFS), the exemption deduction is completely phased out

21. Filing Status
Taxpayer’s filing status determines standard deduction and tax rate schedule
Marital status determined on the last day of the tax year
Separated spouses are considered married until divorce becomes final

22. Filing Status - Married
Can file jointly if both spouses are US citizens or US residents (or if nonresident alien agrees to be taxed on worldwide income)
If the couple files separately, both must itemize deductions or both must use the standard deduction

23. Surviving Spouse
Marital status is determined at the date of death so a joint return can be filed for the year in which a spouse dies
A surviving spouse may continue to use the tax rates and standard deduction for married persons filing jointly for the next 2 years only if a dependent child lives with the taxpayer

24. Filing Status – Unmarried
Unmarried taxpayers file as
Head of household - an unmarried person who provides more than half of the cost of maintaining a home in which a qualifying child or other qualifying relative lives for more than half the year
Single

25. Head of Household
Claimed if taxpayer is unmarried (and not a surviving spouse)
Taxpayer pays more than half the cost of maintaining home which is the principal residence for more than half the year of
A qualifying child
An individual for whom the taxpayer may claim a dependency exemption
A parent is not required to live with the taxpayer

26. Abandoned Spouse
A taxpayer who is married but whose spouse did not live with him or her at any time during the last six months of the tax year and who provides more than half the cost of maintaining the home in which a dependent child lives
A qualifying abandoned spouse uses head of household tax rates and standard deduction

27. Standard Deductions Standard Deductions
$10,000 married filing a joint return
$5,000 married filing separately
$7,300 head of household
$5,000 single individual
Additional standard deduction if taxpayer is elderly (age 65 or older) or blind
$1,250 if single or head of household
$1,000 if married

28. Dependent’s Standard Deduction
Dependent’s standard deduction is limited to the greater of:
$800 or
Earned income + $250 (up to otherwise allowable standard deduction)
Earned income includes salary and wages
Earned income does not include interest income, dividend income, capital gains, or income as beneficiary of a trust

29. Itemized Deductions
Itemized deductions provide tax benefit only to the extent that, in total, they exceed the taxpayer’s standard deduction
Taxpayers can maximize use of the standard deduction and itemized deductions by timing certain deductible payments

30. Medical Expenses
Medical expenses paid for the taxpayer, spouse and dependents, after reduction for insurance reimbursements, are deductible only to the extent they exceed 7.5% of AGI for the year
Qualified medical costs includes prescription drugs and insulin, costs of a hospital, clinic, doctor, dentist, eyeglasses, contract lenses, transportation for medical care and health insurance costs

31. Medical Expenses
Health insurance premiums for taxpayers and their dependents are deductible only if paid from after-tax income
Premiums paid through an employer-sponsored cafeteria plan are not deductible
Premiums for disability insurance and for loss of life, limb or income are not deductible
Premiums for long-term care insurance are deductible, subject to limits based on age

32. Deductible Taxes Deductible taxes include
State, local, and foreign real property taxes
State and local personal property taxes
State, local, and foreign income taxes
Other federal, state, local, and foreign taxes incurred in a business or other income-producing activity
For 2004 & 2005 can elect to deduct state & local general sales taxes instead of state & local income taxes

33. Nondeductible Taxes Nondeductible taxes include Federal income taxes
Employee's share of payroll taxes
Federal excise taxes not incurred for business
Assessments on property that increase property value

34. Interest Expense Deductible interest includes
Investment interest
Home mortgage interest
No deduction for most other personal interest (except previously mentioned student loan interest) including interest on
Auto loans
Life insurance loans
Credit card debt
Delinquent tax payments

35. Investment Interest Expense
Investment interest includes interest on loans to acquire or hold investment property and margin account interest paid to a broker
Investment interest expense is only deductible to the extent of net investment income
Net investment income = excess of investment income over investment expenses
Excess is carried forward (indefinitely) subject to same limit in future years

36. Investment Interest Expense
Investment income includes gross income from interest, annuities, and short-term capital gains from investment property
Long-term capital gains or dividends taxed at favorable rates are excluded unless election made to forgo the favorable rate
Investment expenses include safe deposit box rental fees, investment counsel fees, brokerage account maintenance fees
Limited to the lesser of total investment expenses or net miscellaneous itemized deductions after reduction for 2% AGI floor

37. Qualified Residence Interest
Interest paid for acquisition debt or home equity debt for up to 2 qualified residences
Interest on acquisition debt of up to $1 million principal amount (combined limit for 2 homes) is deductible
Acquisition debt includes mortgage to buy, construct, or improve the residence

38. Qualified Residence Interest
Interest on up to $100,000 principal amount of home equity loan is deductible
Loan proceeds can be used for any purpose
Points (loan origination fees) paid on initial home mortgages are deductible
Points paid to refinance an exiting loan must be amortized over life of loan

39. Charitable Contributions
Congress allows individuals, corporations, estates and trusts to deduct contributions to certain qualified organizations
Partnerships and S corporations pass the contributions through to their partners and shareholders who then claim the deductions on their own income tax returns

40. Charitable Contributions
Qualified charitable organizations
Governmental units (federal, state and local governments) and entities formed and operated exclusively for religious, charitable, scientific, literary or educational purposes, including churches, nonprofit hospitals, school and universities, libraries, and social service agencies
Direct contributions to needy individuals are not deductible

41. Charitable Contributions
No deduction allowed to the extent that valuable goods or services are received in return for the contribution
Exception - contributors to universities who receive preferred rights to purchase tickets for university athletic events may deduct 80% of the amount of their contribution
Individual’s deduction limited to 50% of AGI
Excess contributions may be carried forward up to 5 years

42. Charitable Contributions
No deduction for contributions of the taxpayer’s services and rent-free use of the taxpayer’s property
Out-of-pocket costs incurred for volunteer work for a qualifying charity are deductible
Property other than long-term capital gain property is valued at lesser of FMV or basis

43. Contributions of LTCG Property
LTCG property is valued at FMV (which is usually greater than adjusted basis)
Tangible personalty given to a charity which does not use the property in its tax-exempt activity is valued at adjusted basis, if lower than FMV
Deduction for LTCG property limited to 30% of AGI
30% limit can be avoided (and 50% AGI limit applied) if taxpayer elects to use lower basis
If made, election applies to all LTCG contributions that year

44. Charitable Contributions
Stocks or other income producing property that have declined in value should be sold so that the loss can be claimed with the sale proceeds donated
Fees incurred for appraisals of donated property may be deducted as a miscellaneous itemized deductions
Deduction for donated vehicles sold by charity limited to gross sales proceeds

45. Casualty and Theft Losses
Loss is the lesser of
Asset’s adjusted basis or
Decline in asset’s fair market value as a result of the casualty
Loss is reduced for any insurance proceeds received
$100 floor applies to each casualty
Deductible only to extent total losses exceed 10% of AGI

46. Miscellaneous Deductions
Only excess over 2% of AGI is deductible
Unreimbursed employee business expenses
Job hunting expenses (in searching for a new job in current line of business)
Investment-related expenses
Hobby expenses (up to hobby income)
Tax preparation and planning advice

47. Phaseout of Itemized Deductions
Total deductions phased out by 3% of AGI in excess of $145,950 in 2005 ($72,975 if MFS)
Exception - deductions not phased out for
Medical expenses
Investment interest
Casualty and theft losses
Total deductions are not reduced by more than 80% regardless of type

48. Tax Rates for Married Filing a Joint Return
For married filing a joint return for 2005
10% on first $14,600 taxable income
15% on $14,601 - $59,400
25% on $59,401 - $119,950
28% on $119,951 - $182,800
33% on $182,801 - $326,450
35% over $326,450

49. Tax Rates for Married Filing Separately
For married filing separately for 2005
10% on first $7,300 taxable income
15% on $7,301 - $29,700
25% on $29,701 - $59,975
28% on $59,976 - $91,400
33% on $91,401 - $163,225
35% over $163,225

50. Tax Rates for Single Individuals
For single individuals for 2005
10% on first $7,300 taxable income
15% on $7,301 - $29,700
25% on $29,701 - $71,950
28% on $71,951 - $150,150
33% on $150,151 - $326,450
35% over $326,450

51. Tax Rates for Head of Household
For head of household for 2005
10% on first $10,450 taxable income
15% on $10,451 - $39,800
25% on $39,801 - $102,800
28% on $102,801 - $166,450
33% on $166,451 - $326,450
35% over $326,450

52. Special Tax Rates
Dividend income is taxed at a maximum of 15% (5% for taxpayers in 10% or 15% tax brackets)
Individuals with long-term capital gains file a Schedule D which includes a worksheet for determining the total tax liability

53. Credits vs. Deductions
Deductions only reduce tax liability by a percentage based on the taxpayer’s marginal tax rate
Credits are direct dollar-for-dollar reductions in the gross tax liability
Tax credits have the same dollar value to all taxpayers, regardless of their marginal tax brackets

54. Child Tax Credit
$1,000 nonrefundable tax credit for each qualifying child under age 17
Qualifying children include the taxpayer’s son, daughter, stepson, stepdaughter, grandchild, or eligible foster child that the taxpayer claims as a dependent
Phased out at rate of $50 for every $1,000 (or part thereof) of AGI in excess of
$110,000 if married filing jointly ($55,000 if MFS)
$75,000 if single or head of household

55. Education Credits
Two elective nonrefundable tax credits are provided for college or vocational tuition and fees for the taxpayer, spouse, or dependents
Hope Scholarship Credit – 100% of first $1,000 and 50% of second $1,000 tuition and fees for first 2 years only (maximum $1,500 per student)
Lifetime Learning Credit – 20% of up to $10,000 tuition and fees (maximum $2,000 per taxpayer in 2005)
A student who is a dependent cannot claim the credit

56. Education Credits
Expenses paid with a Pell Grant, scholarship, or employer-provided educational assistance do not qualify
The election is separate for each student, so a parent may choose one credit for one child and a different credit for a second child
Both credits phase out over modified AGI of
$43,000 - $53,000 if single
$87,000 - $107,000 if married filing jointly

57. Earned Income Credit
The purpose is to reduce the impact of payroll taxes for low-income individuals
Credit is equal to a percentage of earned income below a maximum
With one qualifying child, maximum credit is $2,662 ($7,830 x 34%)
With two or more qualifying children, maximum credit is $4,400 ($11,000 x 40%)
Smaller credit available to taxpayers without children

58. Earned Income Credit This is a refundable credit
Taxpayers with investment income of $2,700 or more are not eligible
Anyone who can be claimed as a dependent is not eligible
A taxpayer without a qualifying child, must be between the ages of 25 and 64 to be eligible
Credit starts phasing out when income exceeds $16,370 if married filing jointly ($14,370 for others)

59. Dependent Care Credit
Nonrefundable credit for taxpayers who pay for child or dependent care so they can work
Credit percentage varies from 20% to 35% of up to $4,000 for one qualifying child or $6,000 for 2 or more qualifying children under 13
35% if AGI does not exceed $15,000
Reduced by 1% for each $2,000 (or fraction thereof) AGI exceeds $15,000
20% if AGI exceeds $43,000

60. Retirement Contributions Credit
To encourage participation by low-income wage earners, a credit for up to $2,000 contributed to employer-sponsored retirement plans or IRAs is available
Credit varies with AGI
50% credit for joint filers with AGI up to $30,000 ($15,000 if single)
20% for joint filers with AGI of $30,000 - $32,500 ($15,000 - $16,250 if single)
10% for joint filers with AGI of $32,500 - $50,000 ($16,250 - $25,000 if single)
Dependents or full-time students are not eligible

61. Excess Payroll Tax Credit
Taxpayers working for more than one employer during the year with earnings exceeding the Social Security ceiling ($90,000 for 2005) usually have too much tax withheld
Employee is allowed a refundable credit for any excess Social Security taxes withheld

62. Payment of Income Tax
Estimated quarterly payments are made by persons with large amounts of income from sources not subject to withholding
Due on April 15, June 15, September 15 of current year and January 15 of following year
If payments are not 90% or more of the total tax owed (or an amount required based on the prior year’s tax), a penalty may be charged, unless balance due is less than $1,000

63. Filing Requirements
Any taxpayer whose gross income is less than the sum of their standard deduction and their personal exemption (but not dependency exemptions) does not have to file a tax return
$8,200 in 2005 for a single individual
Returns should be filed if
Net self-employment income is $400 or more
A child claimed as a dependent has unearned income only of over $800
Any married person filing separately has income over $3,200

64. Alternative Minimum Tax
The purpose of the alternative minimum tax is to ensure high-income taxpayers pay their fair share of tax
Certain deductions are disallowed or reduced and certain exempt income items are subject to the AMT
IF AMT is greater than the regular tax, taxpayers pay the larger amount
Rate is 26% on first $175,000 and 28% on excess for individuals

65. AMT Model Taxable income Plus/minus Adjustments to taxable income
Plus: Tax preferences
Less: Allowable exemptions
Equals: Alternative minimum taxable income
Times: AMT tax rates
Equals: Tentative minimum tax (TMT)
Less: Regular income tax
Equals: AMT

66. AMT Exemptions AMT exemptions for 2005 are
$58,000 if married filing jointly
$29,000 if married filing separately
$40,250 if single or head of household
Exemptions begin to phase out when AMTI reaches $112,500 for singles and $150,000 for married filing jointly ($75,000 if MFS) at a rate of $1 for every $4 above the threshold

67. Alternative Minimum Tax
Itemized deductions are different from those calculated for regular income tax
Medical expenses must exceed 10% AGI
Taxes, home equity loan interest, and miscellaneous itemized deductions are not deductible
Tax preferences that are added include
Nontaxable interest on private activity bonds
Bargain element of incentive stock options

68. The End