1. Taxation of Individuals
Chapter 8
Taxation of Individuals
Kevin Murphy
Mark Higgins
©2008 South-Western

2. Taxation of Individuals
Individuals are the biggest single
group of taxpaying entities.
As taxpaying entities, they must
adopt an annual accounting period
and method of accounting.

3. Review of Tax Formula
The formula for calculating taxable income generally is gross income minus allowable deductions.
For individuals, deductions are split into two classes
Deductions for adjusted gross income
Deductions from adjusted gross income

4. Individual Tax Formula
Gross Income
minus: For Deductions
not restricted based on taxpayer’s income
generally trade, business, rent or royalty expenses
Adjusted Gross Income
minus: From Deductions
generally personal expenses
amount is the greater of
Itemized deductions, or
standard deduction allowable

5. Individual Tax Formula
Continued
Adjusted Gross Income [AGI]
minus: From Deductions
minus: Personal & Dependency Exemptions
$3,400 per person

6. Individual Tax Formula
To Taxable Income
Gross Income
minus: For Deductions
equals: Adjusted Gross Income [AGI]
minus: From Deductions
minus: Exemptions
equals: Taxable Income

7. Individual Tax Formula The Tax
Taxable Income
times: Tax Rate
equals: Income Tax Liability
minus: Prepayments & Credits
equals: Tax (or Refund) due

8. Personal and Dependency Exemptions
Each individual taxpayer is allowed one personal exemption
May also claim one exemption for each dependent
Only one exemption may be taken per person per year

9. Dependency Requirements
Two types of dependents
Qualifying child
Must pass five tests: age, non-support, relationship, principal residence, and citizenship
Qualifying relative
Must also pass five tests: gross income, support, relationship, citizenship, and joint-return

10. Qualifying Child Tests
Age Test – Must be
younger than 19, or
a full-time student younger than 24, or
Permanently and totally disabled

11. Qualifying Child Tests
Non-Support Test – Child may not
Supply more than 50% of their own support
Scholarships don’t count
Note: the taxpayer who claims the child does not have to provided more than 50% of the support

12. Qualifying Child Tests
Relationship Test – Child must be taxpayer’s:
Child
Stepchild
Foster child
Sibling
Stepsibling
Decedent of any of the above

13. Qualifying Child Tests
Principal Residence Test
Child must live with taxpayer more than 50% of the year
Absence due to illness, vacation, education, or military service does not count

14. Qualifying Child Tests
Citizen or Resident Test
Child must be a U.S. citizen, or
Resident of the U.S., Canada, or Mexico

15. Qualifying Relative Tests
Gross Income Test
Gross income must be less than the exemption amount of $3,400

16. Qualifying Relative Tests
Support Test
The taxpayer must provide more than 50% of a dependent’s support for the year
Two exceptions apply
Custodial parent may always claim a child
Multiple Support Agreement

17. Qualifying RelativeTests Multiple Support Agreement
When two or more people together provide over half of another’s support, any one who contributes over 10% of the support may claim the exemption
Group must sign a support agreement
May rotate the exemption among the group

18. Qualifying Relative Tests
Relationship Test
A dependent must be related to or reside with the taxpayer
Relatives are ancestors, descendants, and other blood or in-law relations such as siblings, aunts, uncles, nieces and nephews (cousins don’t count, but adopted children do)
Non-relatives must reside in the taxpayer’s home for the entire year

19. Dependency Tests Citizenship or Residency Test
A dependent must be a U.S. citizen or a resident of a country adjacent to the U.S.
Joint Return Test A dependent must not file a joint return
A joint return may be filed simply to claim a refund of all withheld tax

20. Filing Status
Tax law recognizes the difference in ability-to-pay by basing exemptions, standard deductions and tax rates on an individual’s filing status.

21. Filing Status Married, Filing Jointly
Taxpayers must be legally married on the last day of their tax year
A Surviving Spouse may continue to use Married, Filing Jointly status
For two subsequent years
If at least 1 dependent child lives at home
And the surviving spouse has not remarried

22. Filing Status Married, Filing Separately
Taxpayers married as of the last day of the year may choose to file separately

23. Filing Status Head of Household
Unmarried taxpayers qualify if they
Are legally unmarried or an “abandoned spouse” at end of tax year, and
Provide over 50% of the cost of a home for
A qualifying dependent, or
A qualifying child, or
A parent
Parent does not need to live with the taxpayer

24. Filing Status Single
Taxpayers who are not legally married on the last day of the year and do not qualify as Head of Household must file Single

25. Deductions From AGI
Individual taxpayer’s may deduct the larger of either a standard deduction or total itemized deductions.

26. Standard Deductions The standard deduction is based on filing status
Taxpayers who are over 64 years of age receive extra amounts, as do blind taxpayers

27. Itemized Deductions
Through legislative grace, there are 6 categories of personal expenses individual taxpayers may deduct.
Charitable
Contributions
Medical
Taxes
Casualty Losses
Interest
Miscellaneous

28. Medical Expenses
Unreimbursed medical expenses of the taxpayer(s) and medical dependents are deductible
Medical dependents may violate the gross income and the joint return tests
Costs include premiums for health and accident insurance and transportation at 18 cents per mile
Deduction is limited to the excess of total costs over 7.5% of AGI

29. Taxes
Amounts paid for either sales taxes or state and local income taxes are deductible
Amounts paid for real estate and other personal property taxes are deductible
No payments for federal taxes are allowed
Property taxes must be based on value

30. Interest Qualified home mortgage interest is deductible
Debt must be secured by a principal residence
Qualified interest is interest paid for
Acquisition debt up to $1 million
Home equity debt up to $100,000

31. Interest
Points on a qualified mortgage are deductible if paid to acquire financing
Must be stated as a % of the loan value
Deductible currently if paid on acquisition debt
If for refinancing, amortize over the life of the loan

32. Interest
The deduction for investment interest is limited to the amount of net investment income
Investment Income
less: Investment Expenses
Net Investment Income
investment income = portfolio income plus gross income and gains from investment assets
investment expenses do not include interest

33. Charitable Contributions
Contributions made to qualifying charitable organizations are deductible
Organizations established for religious, educational, charitable, scientific or literary purposes qualify
Deductible amount includes cash paid and the value of property given and $0.14 per mile driven
Three major limitations exist
Contributions in excess of limitations may be carried forward for five years
© 2004 South-Western College Publishing
Transparency 8-33

34. Charitable Contributions
Deduction amount for property depends of the type of property given
Ordinary income property or short-term capital gain property
Deduction is the lesser of the property’s
FMV, or
adjusted basis
Deduction amount for long-term capital gain property is FMV

35. Charitable Contributions Limitations
The overall deduction cannot exceed 50% of AGI
Deduction for long-term capital gain property cannot exceed 30% of AGI
If the taxpayer elects to deduct the adjusted basis rather than FMV, the 50% limit is used
Contributions to non-operating private foundations are subject to additional limits

36. Casualty Losses These were discussed in Chapter 7.
Loss is the lesser of
The property’s adjusted basis, or
The decline in the value of the property (repair cost)
Loss is reduced by
Insurance proceeds received,
$100 per event (Administrative convenience), and
10% of AGI per year

37. Miscellaneous Deductions
Other various expenses are combined as miscellaneous itemized deductions and are either fully deductible or partially deductible

38. Miscellaneous Fully Deductible
Fully Deductible expenses include:
Gambling losses to the extent of gambling winnings,
Impairment-related-work expenses of disabled taxpayers, and
Unrecovered capital from a terminated annuity

39. Miscellaneous Partially Deductible
Other miscellaneous expenses are partially deductible to the extent their total exceeds 2% of AGI
Unreimbursed employee expenses
Investment expenses other than interest
Hobby-related expenses

40. Reductions for High-Income Taxpayers
Taxpayers whose AGI exceeds set threshold amounts must reduce their total itemized deductions and their total personal & dependency exemptions.

41. Itemized Deduction Phase-Out
Deductions for medical expenses, investment interest, casualty and theft losses and gambling losses are not subject to reduction
Calculated phase-out amount for taxpayers with AGI over $156,400 is the smaller of
3% of (AGI - $156,400), or
80% of the amount subject to reduction

42. Exemption Phase-Out
Initial calculation for taxpayers with AGI over a threshold amount is
AGI - Threshold
2% X
$2,500

43. Exemption Phase-Out Threshold Amounts

44. Restrictions on Dependents
A person claimed as a dependent by another taxpayer
May not also claim a personal exemption
May report a standard deduction of
$850, or
The amount of earned income plus $300, but not more than the regular standard deduction amount

45. Restrictions on Dependents
The net unearned income of a child under the age of 14 is taxed at the parent’s marginal tax rate
Unearned Income
less: $1,700
Net Unearned Income

46. Tax Credits A tax credit is a direct reduction of tax liability.
The purposes of tax credits are
to provide incentives for taxpayers to engage in specific activities
to provide equity among taxpayers
to provide tax relief for low-income taxpayers

47. Child Tax Credit
Non-refundable $1,000 credit for each qualifying child who is under age 17
Phased-out at rate of $50 for each $1,000 of AGI greater than
$110,000 if MFJ, $55,000 if MFS, $75,000 for others

48. Child Credit May Be Refundable
With one or two children
Refund amount = 15%(Earned Income - $11,750)
With three or more children
Amount = 15%(Earned Income - $11,750), but
Limited to tax liability + Social Security tax paid - Earned Income Credit

49. Earned Income Credit
The earned income credit provides tax relief to low-income taxpayers
Credit is refundable
The taxpayer may receive a refund if the credit exceeds the tax liability

50. Earned Income Credit Eligibility Requirements
Taxpayer or spouse
Must live more than half the year in the U.S.
Must be older than 25 and younger than 65
Cannot be a dependent of another
May not have portfolio or passive income in excess of $2,800
Married taxpayers must file jointly

51. Earned Income Credit Amount
Amount of the credit depends on
The taxpayer’s earned income
Phased-out after maximum limit is reached
The number of qualifying children living in the taxpayer’s home
Child must be less than 19 years old (24 if full-time student)
Must be a natural, step, or foster child and reside with taxpayer more than half of the year
Amount is determined using an IRS table

52. Child and Dependent Care Credit
The child and dependent care credit provides tax relief to taxpayers so that they can be employed
Two qualifying conditions must be met
Expenses must be incurred so that taxpayer can be employed
Expenses must be for the care of qualified individuals

53. Child and Dependent Care Credit Qualifications
Qualified individuals are
Dependents younger than 13 years old, or
A dependent or spouse who is physically or mentally incapacitated
The credit amount may not exceed $3,000 ($6,000 if more than one qualified individual)

54. Child and Dependent Care Credit Reductions
Credit amount is 35% of qualified expense
Percentage is reduced as AGI exceeds $15,000, but never below 20%
AGI - $15,000
35% - (1% X )
$2,000

55. Higher Education Credits
Two credits
HOPE Scholarship Credit
Lifetime Learning Credit
May claim only one per qualifying student
Must be enrolled at least one semester
Must be enrolled at least half-time
May not claim if deduction taken for Higher Education Expenses

56. Higher Education Credit Qualifying Expenses
Expenses must be for higher education of taxpayer, spouse, or dependent
Tuition and related fees are reduced by the amount of any scholarship or fellowship received

57. HOPE Scholarship Credit
Maximum non-refundable $1,650 credit
100% of the first $1,100, plus 50% of the second $1,100
May be claimed by student or qualifying taxpayer
Separate credit for each student

58. HOPE Scholarship Credit Limitations
Available only for first two years of post-secondary education
Phased-out for AGI greater than
$94,000 if MFJ
$47,000 if other
Possible credit X [1 - {(AGI - phase-out) / 20,000}]

59. Lifetime Learning Credit
Maximum non-refundable $2,000 credit
20% of the first $10,000 of qualifying expenses
Only one credit per return (regardless of number of students in household)
Expense can be for any course work to acquire or improve job skills
Phased-out same as HOPE Credit
Transparency 8-59

60. Filing Requirements
Individuals must file a return when gross income > (standard deduction + additional deductions for age + personal exemption)
3 exceptions:
Self-employment income exceeds $400
MFS whose gross income exceeds $3,400
Can be claimed as a dependent on another’s return and unearned income exceeds $850