1. Individual Income Tax Overview
Chapter 04
Individual Income Tax Overview

2. Individual Income Tax Formula
Gross income
Minus: For AGI deductions
Equals Adjusted gross income
Minus: From AGI deductions:
Greater of (a) Standard deduction or
(b) Itemized deductions
and
Personal and dependency exemption
Equals Taxable income

3. Individual Income Tax Formula
Taxable income
Times: Tax rates
Equals: Income tax liability
Add: Other taxes
Equals: Total tax
Minus: Credits
Minus: Prepayments
Equals: Taxes due or (refund)
Please insert exhibit 4-1 on this slide where indicated

4. Individual Income Tax Formula
Individuals report taxable income to the IRS
Reported on Form 1040
U.S. tax laws use all-inclusive income concept
Realized income
measurable change in property rights
All realized income included in gross income unless specifically excluded or deferred
Recognized income
Reported on tax return

5. Individual Income Tax Formula
Excluded and Deferred income not included in gross income
Excluded income
Income never included in taxable income
Municipal bond interest
Gain on sale of personal residence
Deferred income
Income included in a subsequent tax year
Installment sales
Like-kind exchanges

6. Individual Income Tax Formula
Character of income or loss
Determines rates applicable to income or loss in current year
Tax exempt – no tax
Tax deferred – no tax in current year
Ordinary – ordinary rates from tax rate schedule
Qualified dividends – 0 or 15%
Capital gain or loss – depends on whether short-term or long-term
From selling capital asset
If held capital asset more than a year gain or loss is long-term, otherwise it is short-term

7. Individual Income Tax Formula
Capital assets
Generally all assets except
Accounts receivable
Inventory
Assets used in trade or business, including supplies

8. Individual Income Tax Formula
Capital gains and losses
Long-term capital gains generally taxed at 0%, 15%, or 20% depending on the taxpayer’s taxable income
Short-term capital gains taxed at ordinary rates
Net capital losses (losses in excess of gains for year)
$3,000 deductible against ordinary income for year
Losses in excess of $3,000 carried forward

9. Individual Income Tax Formula
Deductions for AGI
Deductions “above the line”
Deducted in determining adjusted gross income
Always reduce taxable income dollar for dollar

10. Individual Income Tax Formula
Deductions from AGI
Deductions “below the line”
Deducted from adjusted gross income to determine taxable income
Greater of standard deduction or itemized deductions
Personal and dependency exemptions
Why might a from AGI deduction not reduce taxable income?

11. Individual Income Tax Formula
2013 Standard deduction amounts
$12,200 Married filing jointly
$12,200 Qualifying widow or widower
$6, Married filing separately
$8, Head of household
$6, Single
Additional standard deduction amounts for age and eyesight (discuss in Chapter 6)

12. Individual Income Tax Formula
Tax calculation
The U.S. uses a progressive tax rate schedule
Some items are taxed at preferential rates
Long-term capital gains
Qualified dividends
Tax on these items is calculated separately from income taxed at ordinary rates.

13. Individual Income Tax Formula
Other taxes include:
Alternative minimum tax
Self-employment taxes
Medicare Contribution tax on net-investment income
Tax credits
Reduce tax liability dollar for dollar

14. Individual Income Tax Formula
Tax prepayments
Payments already made towards tax liability including:
Income taxes withheld from wages by employer
Estimated tax payments made during the year
Taxes overpaid in prior year and applied toward current year’s liability
If prepayments exceed tax liability after credits, taxpayer receives a refund

15. Personal and Dependency Exemptions
Personal exemptions
For taxpayer and spouse if married filing jointly
Dependency exemptions
For those who qualify as the taxpayers’ dependents
Exemption amount for 2013 is $3,900

16. Personal and Dependency Exemptions
Dependency requirements
Citizen of U.S. or resident of U.S., Canada, or Mexico
Must not file joint return with spouse
Exception – if no tax liability filing jointly or separately
Must be qualifying child or qualifying relative of taxpayer

17. Personal and Dependency Exemptions
Qualifying child
Relationship test
Age test
Residence test
Support test

18. Qualifying Child Relationship test
taxpayer’s son, daughter, stepchild, an eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister or a descendant of any of these relatives.

19. Qualifying Child
Age test: child must be younger than the individual claiming the child as a qualifying child and either-
under age 19 at the end of the year,
under age 24 at the end of the year and a full-time student, or
permanently and totally disabled.

20. Qualifying Child Residence test Support test
Same residence as taxpayer for more than half the year
Exception for temporary absences such as education.
Support test
Child must not provide more than half of his or her own support
Scholarships of actual child (not grandchild, for example) are excluded from support computation

21. Qualifying Child Example
Rodney and Anita have two children: Braxton, age 12, who lives at home and Tara, age 21 who is a full-time student and does not live at home. While Tara earned $9,000 in a summer job, she did not provide more than half of her own support during the year. Are Braxton and Tara qualifying children to Rodney and Anita?

22. Qualifying Child Example Solution
Test
Braxton
Tara
Relationship
Yes, son
Yes, daughter
Age
Yes, < 19 at year-end (and younger than his parents)
Yes, < 24 at year-end and full-time student (and younger than his parents)
Residence
Yes, lived at home entire year
Yes, temporary absences such as school ok
Support
Yes, he provides < ½
Yes, parents provide > ½ (scholarship does not count as self -support)

23. Qualifying Child Tie breaking rules Parents first
Days living with each parent if parents living apart
AGI– higher AGI gets exemption

24. Qualifying Child Example
Braxton’s uncle Shawn (Rodney’s brother) lived in the Halls’s home (the same home Braxton lived in) for more than 11 months during Does Braxton meet the requirements to be considered Shawn’s qualifying child?

25. Qualifying Child Example Solution
Test
Is Braxton Shawn’s qualifying child?
Relationship
Yes, son of Shawn’s brother
Age
Yes, < 19 at year-end (and younger than Shawn)
Residence
Yes, lived in the same residence as Shawn for more than half the year
Support
Yes, does not provide more than half of own support

26. Qualifying Child Example
Braxton is considered to be Rodney and Anita’s qualifying child and he is considered to be Shawn’s qualifying child. Under the tiebreaker rules, who is allowed to claim Braxton as a dependent for the year?

27. Qualifying Child Example Solution
Answer: Rodney and Anita. Under the first tiebreaking rule, Rodney and Anita are allowed to claim the dependency exemption for Braxton because they are Braxton’s parents.

28. Personal and Dependency Exemptions
Qualifying relative
Relationship test
Support test
Gross income test

29. Qualifying Relative Relationship test
a descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent),
a sibling of the taxpayer or a stepmother, stepfather, stepbrother, stepsister, nephew, niece, aunt, uncle (but cousins do not qualify)
in-law (mother-in-law, father-in-law, sister-in-law, brother-in-law, son-in-law, and daughter-in-law) of the taxpayer, or
unrelated person who lives in taxpayer’s home entire year (cousins may qualify this)

30. Qualifying Relative Support test Gross income test
Taxpayer must pay > ½ of living expenses (support)
Scholarships of actual child excluded
Gross income test
Gross income < personal exemption amount

31. Dependency Exemption Example
John is a 22-year old student who has lived in the dorms for most of the year but spends the rest of the year living with his parents. He earned a $5,000 scholarship for the school year and has worked hard to support himself through school earning $6,000 to pay for his own expenses. His parents have supported him by paying for $7,000 for food, clothing, and lodging expenses. Are John’s parents able to claim him as a dependent?

32. Dependency Exemption Example Solution
Test
Qualifying child
Qualifying relative
Relationship
Yes, child
Age
Yes, < 24 and full-time student
Not applicable
Residence
Yes, temporary absences ok
Support
Yes, he provides < ½
Yes, parents provide > ½
Gross income
No, gross income > $3,900

33. Personal and Dependency Exemptions

34. Filing Status Five different filing statuses Married filing jointly
Married filing separately
Qualifying widow or widower (surviving spouse)
Single
Head of household

35. Filing Status Married filing jointly
Must be married on the last day of the year
If one spouse dies the surviving spouse is considered to be married to decedent spouse at year end
Exception – The surviving spouse remarries before year end
Joint and several liability for tax

36. Filing Status Married filing separately
Taxpayers are married but file separate returns
Typically not beneficial from tax perspective
Tax rates and other tax benefits
May be beneficial for non-tax reasons
No joint and several liability

37. Filing Status Qualifying widow or widower
Available for the two years following the year of spouse’s death
Surviving spouse does not qualify if remarries during two-year period.
Surviving spouse must maintain household for dependent child

38. Filing Status
Single
Unmarried unless qualify for head of household

39. Filing Status Head of household
Unmarried or considered unmarried at end of year
See abandoned spouse discussion
Not a qualifying widow or widower
Pay more than half the costs of keeping up a home during the year
Lived in taxpayer’s home with a “qualifying person” for more than half of the year
Exception for parents (see below)

40. Filing Status Qualifying person Qualifying child
Qualifying relative who is taxpayer’s mother or father
Parent need not live with taxpayer
Taxpayer must pay > ½ cost of maintaining separate household for taxpayer’s mother or father
Parent must qualify as taxpayer’s dependent

41. Filing Status Qualifying relative who is not the taxpayer’s parent
Person must have lived with taxpayer for more than half the year
Must qualify as taxpayer’s dependent
Must be related to taxpayer through qualified family relationship
If related only because lived with taxpayer for entire year, not a qualified person.

42. Filing Status Head of household
Married individuals treated as unmarried (abandoned spouse) if individual
Is married at end of year (or is not legally separated from the other spouse)
Does not file a joint tax return with the other spouse
Pays > ½ the cost of maintaining a household that serves as principal abode for qualifying child for more than half the year
Lived apart from the other spouse for the last six months of the year (other than temporary absences)

43. Filing Status Example
Assume that last year Rodney passed away, and during the current year Anita did not remarry but maintained a household for Braxton and Tara, her dependent children. Under these circumstances, what would Anita’s filing status be?

44. Filing Status Example
Answer: Qualifying widow

45. Filing Status Example
Assume Rodney and Anita divorced last year. During the current year, Braxton lives with Anita and Anita pays all the costs of maintaining the household for herself and Braxton. Under these circumstances, what is Anita’s filing status for the current year?

46. Filing Status Example
Answer: Head of household

47. Filing Status Example
Assume Shawn (Rodney’s brother) lived with the Halls, but Shawn paid more than half the costs of maintaining a separate apartment that is the principal residence of his mother, Sharon, whose gross income is $1,500. Because Shawn provided more than half of Sharon’s support during the year, and because Sharon’s gross income was only $1,500, she qualifies as Shawn’s dependent (as a qualifying relative). In these circumstances, what is Shawn’s filing status?

48. Filing Status Example
Answer: Head of household. Shawn paid more than half the costs of maintaining a separate household that is the principal place of abode for his mother, and his mother qualifies as his dependent.