1. The Individual Tax Formula
Chapter 14
The Individual Tax Formula
McGraw-Hill Education
Copyright © 2015 by McGraw-Hill Education. All rights reserved.

2. Objectives Determine an individual’s filing status
List the four steps for computing individual taxable income
Explain the relationship between the standard deduction and itemized deductions
Compute an exemption amount
Compute the regular tax on ordinary income

3. Objectives (continued)
Explain why a marriage penalty exists in the federal income tax system
Describe the child credit and dependent care credit
Recognize circumstances that may trigger the individual AMT
Describe the individual tax payment and return filing requirements

4. Filing Status Filing status Affects calculation of taxable income
Determines rates at which income is taxed
Reflects marital and family situation

5. Filing Status - Married
MFJ or MFS if married on the last day of the year
MFJ (married filing joint) rates
If spouse incomes are similar, single rates generate lower overall tax
If spouse incomes are dissimilar, married rates generate lower overall tax
MFJ rates apply to Surviving Spouse status
A widow/widower with a dependent child for two years after death of spouse
MFS (married filing separately) rates are less favorable than single

6. Filing Status - Unmarried
Head of Household filing status may be used if the taxpayer maintains a home for either a:
Child (need not be dependent), or
Dependent relative
Single is the default filing status for unmarried individuals

7. Filing Status Examples
Determine Mr. J’s filing status in 2014
Mr. J and Mrs. J were divorced on November 18. Mr. J has not remarried and has no dependent children
Mr. J and the first Mrs. J were divorced on April 2. Mr. J remarried the second Mrs. J on December 15. He has no dependent children
Mrs. J died on July 23. Mr. J has not remarried and has no dependent children
Mrs. J died on October 1, Mr. J has not remarried and maintains a home for one dependent child
Mrs. J died on May 30, Mr. J has not remarried and has no dependent children.
Mr. J and Mrs. J were legally divorced on May 30, Mr. J has not remarried and maintains a home for two dependent children.

8. Taxable Income Computation
Step 1: Calculate total income
Step 2: Calculate adjusted gross income (AGI)
Step 3: Subtract itemized deductions or standard deduction
Step 4: Subtract exemption amount

9. Step One Total income includes: Salary, wages, fringe benefits
Net business income
Income from sole proprietorship
Income from partnership or S corporation
Investment income
Interest
Dividends
Capital gains
Rental income

10. Step Two
Adjusted gross income (AGI) equals total income less specific above-the-line deductions
AGI is an important number because many deductions and credits are limited by reference to AGI

11. Step Three Subtract the greater of: Allowable itemized deductions
Standard deduction

12. Standard Deduction (2014) Depends on filing status
MFJ = $12,400
MFS = $6,200
HOH = $9,100
Single = $6,200
Blind or age 65 or older
MJF, MFS = additional $1,200
HOH or Single = additional $1,550
Dependent on another return
Limited to lesser of $1,000 or earned income plus $350

13. Itemized Deductions See Schedule A (Chapter 17 details)
Only one-third of individual filers elect to itemize deductions
Bunching: if itemized deductions are close to standard deduction each year, taxpayer should bunch deductions in alternate years

14. Individual Tax Deductions
Above-the-line deduction always reduces taxable income
Itemized deduction may have limited or no effect on taxable income
Classification as either above-the-line or itemized deduction often reflects tax policy and can change from year to year

15. Overall limitation on itemized deductions
Individuals with AGI in excess of a threshold amount must reduce total itemized deductions by 3% of excess AGI
Reduction limited to 80% of total itemized deductions
Limitation has no effect on standard deduction
Computation is presented in Appendix 14-A

16. Step Four Subtract exemption amounts
Exemption is $3,950 for 2014
Each taxpayer is allowed a personal exemption
Two exemptions are allowed for MFJ
No personal exemption if claimed as another taxpayer’s dependent
Taxpayer is allowed a dependency exemption for:
Qualifying child
Qualifying relative

17. Exemption phaseout
Individuals with AGI in excess of a threshold amount must reduce their total exemption amount by a percentage determined with reference to such excess
Phaseout can reduce exemption amount to zero
Computation is presented in Appendix 14-B

18. Summary of Four-step Procedure
Total income
(Above-the-line deductions)
Adjusted gross income (AGI)
(Itemized deductions or standard deduction)
(Exemption amount)
Taxable income

19. Tax Computations Calculate 2014 tax on $100,000 taxable income
MFJ status
$10, ($100,000 - $73,800) = $16,712.50
Single status
18, ($100,000 - $89,350) = $21,175.75

20. Marriage Penalty Dilemma
Federal income tax is not marriage neutral
Limited relief for lower income taxpayers
10% and 15% brackets for MFJ are twice that for singles
Standard deduction for MFJ is twice that for singles
Progressive tax system that allows married couples to file joint returns can be marriage neutral or horizontally equitable – but not both!

21. Kiddie Tax
Children who earn income in their own name must file their own tax return
If child is claimed as a dependent on another taxpayer’s return:
Limited standard deduction
No personal exemption
Unearned income (in excess of $2,000) of children under age 18 is taxed at parents’ marginal rate 23

22. Credits Child credit = $1,000 per child under age 17
Phases out for high-income taxpayers
Dependent care credit for children < 13 years old or dependents who can’t care for themselves
Credit is between 35% and 20% of child care costs depending on AGI

23. Credits (con’t) Earned income credit is refundable
Transfer payment to working poor that increases progressivity of tax rates
Credit is higher for taxpayers with children and phases out as AGI increases
Excess Social Security tax withholding is refunded as a credit against income tax

24. Individual AMTI
Individuals are subject to AMT on their AMTI in excess of an exemption
Exemption amount based on filing status
AMTI = taxable income +/- AMT adjustments + preference items
Positive adjustments include standard deduction and exemption amount

25. AMT Computation Tentative minimum tax:
26% on first $182,500 excess AMTI (2014)
28% on additional excess AMTI
AMT is any excess of tentative AMT over regular income tax for the year
Individuals pay both regular income tax and AMT
Total tax equals tentative minimum tax

26. Payment and Filing Requirements
Income taxes on salaries and wages are withheld each pay period
Estimated taxes on self-employment and investment income are due on April 15, June 15, September 15, and January 15

27. Payment and Filing Requirements
Underpayment penalty avoided by paying:
90% of current year tax
100% of prior year tax (110% if AGI > $150,000)
Form 1040 must be filed by April 15
Automatic extension until October 15
Balance of tax due must be paid with extension request