1. Individual Income Tax Computation and Tax Credits
Chapter 8
Individual Income Tax Computation and Tax Credits

2. 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.

3. 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.

4. 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

5. 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

6. 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

7. Tax Computation Example
Assume that Gram’s taxable income is $37,400 including $4,000 of qualifying dividends taxed
at the preferential rate. What would be Gram’s tax liability on her income under these circumstances?

8. Tax Computation Example Solution

9. Net Investment IncomeTax
3.8% tax imposed on lesser of:
Net investment income (e.g., interest, dividends, annuities, royalties, rents, passive activity income, net gains from disposing of property, less related allowed deductions) or
Excess of modified AGI over $250,000 (MFJ), $125,000 (MFS), and $200,000 (all others)

10. Federal Income Tax Computation
Kiddie tax
Net unearned income taxed at parents’ marginal rate
Net unearned income = unearned income in excess of $2,000
Parents can elect to actually include this income on their tax return.
Applies if
Child is under age 18 at year end,
Child is 18 at year end but earned income not greater than half of child’s support, or
Child is over age 18 but under age 24, is a full-time student, and child’s earned income not greater than half of child’s support.

11. Kiddie Tax Example
Suppose that during 2014, Deron received $1,100 in interest from an IBM bond, and he received another $2,100 in interest income from a money market account that his parents have been contributing to over the years. What is Deron’s taxable income and corresponding tax liability? (Deron’s mother Courtney is subject to a 25% marginal tax rate.)

12. Kiddie Tax Example Solution
Because Deron is younger than 18 years of age at the end of the year and his net unearned income exceeds $2,000, he is potentially subject to the kiddie tax.

13. Kiddie Tax Example Solution (cont’d)

14. Alternative Minimum Tax Formula

15. 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

16. Alternative Minimum Tax
Exemption phased out 25 cents for each dollar over threshold

17. 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

18. 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%

19. 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)
$117,000 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

20. 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 $117,000 limit applies to Social Security portion

21. Employment and Self-Employment Taxes
If net earnings from self-employment < $400, no SE tax.
How does $117,000 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?

22. Employment and Self-Employment Taxes Example
Assume that Courtney received $100,000 of taxable compensation from EWD in 2014, and she received $180,000 in self-employment income from her weekend consulting activities. What amount of self-employment taxes is Courtney required to pay on her $180,000 of business income?

23. Employment and Self-Employment Taxes Example Solution

24. 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

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

26. 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 8-9)

27. Nonrefundable Personal

28. 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

29. American Opportunity Credit Example
Courtney paid $2,000 of tuition and $300 for books for Ellen to attend the University of Missouri–Kansas City during the summer at the end of her freshman year. What is the maximum American opportunity credit (before phase-out) Courtney may claim for these expenses?

30. American Opportunity Credit Example Solution
Answer: $2,075.
Because the cost of tuition and books are eligible expenses, Courtney may claim a maximum American opportunity credit before phase-out of $2,075 [($2,000 × 100%) + ($2,300 - $2,000) × 25%].

31. American Opportunity Credit Example
Assuming Courtney qualifies for a $2,075 American opportunity credit, she is married filing jointly, and her AGI is $162,000, what amount of American opportunity credit would she be allowed to claim after phase-out?

32. American Opportunity Credit Example Solution

33. 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

34. 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

35. 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 8-10

36. Refundable Personal

37. 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

38. Tax Credits

39. 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

40. 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

41. 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%

42. 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

43. Prepayments and Filing Requirements
Due dates
April 15th
Extend filing up to six months
May not extend due date for paying taxes

44. 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

45. Late Filing and Late Payment Penalty Example
Assume Courtney filed her tax return on April 10 and included a check with the return for $2,860 made payable to the United States Treasury. The $2,860 consisted of her underpaid tax liability of $2,830 and her $30 underpayment penalty. If Courtney had waited until May 1 to file her return and pay her taxes, what late filing and late payment penalties would she owe?

46. Late Filing and Late Payment Penalty Example Solution
Answer: Her combined late filing penalty and late payment penalty would be $142 ($2,830 late payment × 5 percent × 1 month or portion thereof). Note that the combined late filing and late payment penalty is limited to 5 percent per month.