1. Chapter 14 The Individual Tax Model

2. Filing Status - Married  If married on the last day of the year: status must be either Married filing joint or Married filing separately.  MFJ rates apply to Surviving Spouse  widow or widower with a dependent child for two more years after death of spouse.  MFS (married filing separately) rates are less favorable than single.  Generally only used for separated couples or US citizens or residents married to a nonresident alien

3. Filing Status - Unmarried  Single is the default category for unmarried individuals (neither surviving spouse nor head of household).  Head of household - maintain a home for either  child (need not be dependent)  dependent relative

4. Taxable Income Computation Taxable Income Computation  Calculate total income totaling Line 22 on 1040.  Calculate Adjusted Gross Income (AGI) on Line 37 of 1040.  Subtract the greater of:  itemized deductions or  the standard deduction  Subtract total exemptions  Result is Taxable Income

5. Individual Tax Model – Gross Income / Exclusions  General Rule: Gross Income is “Broadly Conceived”: Includes all income subject to taxation unless specifically indicated as not taxable by law.  Exclusions include:  unrealized gains, gifts, inheritances, welfare type payments, many fringe benefits, returns of capital, Municipal Interest, some US Govt for higher education, life insurance proceeds.  Scholarships - excludible if  recipient is candidate for degree, amount received is not a payment for services, and is used to pay tuition, books, and other similar educational expenses  Foreign earned Income (Sec. 911) - build U.S. Economy  Exclude up to $100,800 of foreign earned income annually plus a housing allowance (exclusion cannot exceed earned income  Individual must be a bona fide resident of the foreign country for an entire tax year or be in the foreign country for 11 mos in any 12 month period.

6. Individual Tax Model: Special Income Inclusions  Annuities: Amount not taxed: Inv. / Expected Return * Pymts Rec  Deferred Compensation Plans: Defined Contribution Plans, Defined Benefit Plans - Qualified Retirement Plans  Prizes and Awards - include FMV  Social Security Benefits - up 85% may be taxed  Unemployment compensation is taxable  Alimony received is taxable / Child support is not includible but is not deductible either.

7. Special Rules  Dividends (cash and noncash) - FMV of prop received (subject to E& P provisions)  Stock dividends generally not taxable  Damages - personal (special rules) business damages not excludible.  Discharge of indebtedness - generally includible.

8. Business versus Investment  Business activity  Time and talent on regular basis  Profit partially attributable to personal involvement  Income is considered earned income  Hobby losses only deductible to extent of hobby income – not a business activity  Investment activity  Passive role as owner of income-producing property  Income is considered unearned income  Losses on personal use assets are not deductible – gains from sale are treated as capital assets.

9. Investments in Financial Assets  Securities include:  common and preferred stock  savings accounts, CDs, notes, bonds  Return on / Income from investment includes  Interest (ordinary income)  Dividends (special rules post May 2003)  Reinvested dividends are still taxable but increase basis.  gains (losses).  Mutual funds may report ‘distributed’ capital gains/losses. These are still taxable but increase basis even if no cash received.

10. Gains/Losses on Securities  Realization requires a sale or exchange  Gain/loss = Proceeds - adjusted basis  Character is capital - time period matters  Basis issues  reinvested dividends increase basis.  Sale of stock uses either specific ID or FIFO method of matching basis with sales.  Mutual fund shares sold typically use an average basis.

11. What to do with Capital Gains and Losses  SHORT TERM asset held for <= 1 year – gains taxed as ordinary income  LONG TERM asset held for > 1 year  L/T Gains taxed at lower capital gains tax rate of 20%  Net the gains and losses in each class (net ST, net LT, net 28%LT).  Special rule for sale of principal residence  Exclude gain up to the amount of statutory exclusion if home is principal residence 2 years out of 5 years ending on date of sale.  Exclude only one gain every 2 years.  Limits $500,000 MFJ, $250,000 other

12. Deductions for Adjusted Gross Income and AGI  Deductions for Adjusted Gross Income  Trade/Business Exp from a Sole Proprietorship are reported on Schedule C / or for a rental property are recorded on schedule E  Student Loan interest up to $2500 (Income limits apply)  Self Employed Expenses: 50% of SE tax, percentage of health insurance premiums, Keogh and Simple retirement plans  IRAs, Moving Expenses, Contributions to MSAs  Penalty for early withdrawal of savings  Result of Income less deductions for Adjusted Gross Income –is AGI (very key concept) - many deductions are a function of AGI (e.g., IRA deductions, medical expenses, charitable contributions)  Many items of gross income are also a function of AGI  Social Security Benefits, Passive Activity Losses

13. Deductions from AGI: Standard Deduction or Itemized Deductions  Standard Deduction Depends on filing status. For 2014/15:  MFJ = $12,400/$12,600  MFS = $6,200/$6,300  HOH = $9,100 / $9,250  Single = $6,200/$6,300  Blind or aged (>=age 65)  MJF, MFS = additional $1,200/$1,250  HOH or Single = additional $1,550  Take the higher of Standard Deduction or Itemized Deductions as a reduction of AGI in the computation of Taxable Income – Discussion of Itemized Deductions follows

14. Itemized Deductions / Personal Losses - Chapter 17  Itemized deductions  a special class of deductions that allow taxpayers to derive tax benefits from certain personal & investment expenditures  Individuals deduct the greater of the standard deduction for his/her filing status or the total of his/her itemized deductions.  About 1/3 of all TPs claim itemized deductions  Itemized deductions are shown on Form 1040 Schedule A.

15. Medical Expense Deduction  Sec. 213 - qualified non-reimbursed medical expenses for a TP and dependents qualify for a deduction subject to a 10% of AGI floor (7.5% if over 65) - only 5% of TPs benefit  Qualifying expenses include  Medical insurance premiums / prescription drugs  Medical treatment / Physical & Psychological treatment  medical products, glasses, artificial limbs etc.  Capital improvements - limited to excess over increase in home value due to the improvements.  Capital improvements to remove structural barriers for physically handicapped - fully deductible.  Cosmetic surgery if it results from disease, personal injury or congenital defects.  No deduction allowed for:  Elective cosmetic surgery

16. TaxesTaxes  Sec 164 - lists deductible taxes  In general - only income taxes (other than Federal) and property taxes - ad valorem taxes on investment and personal property are deductible.  Taxes must be distinguished from assessments, fines & penalties which are not deductible.  Taxes are only deductible when they are the taxpayers obligations. No deduction for paying another persons taxes. No deduction is someone else pays your taxes.  50% of SE tax is deductible,  Sales tax are deductible if total is greater than income taxes paid to a particular state.

17. InterestInterest  Sec 163 - certain types of interest paid or accrued by a taxpayer during the year is deductible  Mortgage interest, some points, home equity interest or investment interest - are individual itemized deductions  Investment interest expense- deductible to extent of net investment income ( Gross Inv. Inc - Inv. Exp.)  Inv. Interest deduction not allowed if used to purchase tax exempt securities.  Qualified Residence Interest  indebtedness used to purchase, construct or improve the taxpayers residence  2 homes allowed -Int on debt up to $1 Million is ded..  Home equity interest limited to principal of 100K  Point on new loan or improvement loan deductible when paid. Refinancing - amortized over loan life.

18. Charitable Contributions  Sec 170 - gifts to qualified charities is deductible  Qualified charities: U.S. based organizations operated exclusively for religious, charitable, scientific, literary or educational purposes or for the prevention of cruelty to children or animals.  Contribution amount  reduced by value of any benefit received by the donor  LTCG property = value is FMV  No deduction allowed for contribution of services or rent free use of property.  Contribution Limits  LTCG property - limited to 30% of AGI  Total contributions limited to 50% of AGI  Excess contributions can be carried forward 5 years  If contributing property, TP must be able to substantiate value.  Must file form 8283 if noncash contributions > 500  Independent appraisal is required when a single item of donated property is valued in excess of $5,000.

19. Casualty Losses / Miscellaneous Itemized Deductions  Casualty losses - unreimbursed losses due to theft or casualty. Losses are reduced by $100 and 10% of AGI. Excess, if any is deductible as an itemized deduction.  Misc. deductions subject to 2% of AGI limitation- (must exceed 2% of AGI to be deductible)  Unreimbursed Employee Business Expenses - union dues, uniforms, business use of auto, job search, other prof. Dues  Expenses for managing or safeguarding assets: safe deposit rental, investment advice, investment publications  Tax determination expenses: Tax prep fees, legal representation in tax audit, legal and accounting fees for tax planning, appraisals for tax reporting  Misc. deductions not subject to 2% limitation  gambling losses to extent of gambling winnings  unrecovered investments in annuities due to annuitants death.

20. ExemptionsExemptions  Personal exemption for the taxpayer (2 for MFJ).  If you are a dependent on someone else’s return, can you still claim yourself?  Exemption = $3,950/$4,000 in 2014/15 for each personal or dependency exemption.

21. Exemptions for Dependents  Family member OR live in your home for entire year.  You provide > 1/2 financial support  Dependent’s gross income < exemption amount ($3,950 for 14)  waived for child < 19 OR student-child<24  Dependent may not generally file a joint return.  Dependent must be a U.S. citizen OR a resident of US, Mex, Canada

22. Rich People  Phase-out of itemized deductions – Repealed in 2010 – returned effective for 2013 – Haircut (reduction in allowed itemized deductions) = AGI – Threshold ($305,050/ $309/900 (2014/15) for MFJ) * 3%.  Phase-out of exemptions – Repealed in 2010. Returned effective 1/1/2013. For our class assume if AGI is greater than $435,000 then no personal exemptions are allowed. If AGI < $435,000 allow full amount of exemptions.  Tax on net investment income (dividends, interest, capital gains, net income on passive activities): 3.8% for individuals with income in excess of $200,000, MFJ in excess of $250,000. Please know it exists but we will not compute the tax on our assignments for this course.

23. Tax Credits  A credit is a dollar for dollar reduction in the tax liability. A deduction only reduces the tax by the marginal tax rate associated with that deduction.  Child Credit = $1,000 per child in 2014 Phases out for rich.  Dependent care credit (child < 13 years old). Credit amount between 30% and 20% of child care costs depending on income range.  Earned income credit. This is refundable - a transfer payment to working poor. Increases progressivity of tax rates. Credit is higher for taxpayers with children and phases out as income increases.  Excess FICA withholding is refunded through a tax return claim.

24. Tax Subsidies for Education  Hope scholarship credit / American job opportunity cred - 1st 4 years of college. Max $2500 per year per student based on tuition/fees. Phase out for MFJ between $160-180K)  Lifetime learning credit = 20% of tuition/fees: Max $5000 per year. Lifetime credit phase out begins $110- 130K for MFJ  Education IRA - withdrawals spend on education are tax-free.

25. Payment and Filing Requirements  Taxes on wages are withheld each pay period.  Estimated taxes are due on April 15, June 15, September 15, and January 15.  Pay 90% of current year tax, 100% of prior year (or 110% of prior year AGI>$150,000).  Tax return due 4/15, but may be extended to 10/15 (LAST DATE).

26. Kiddie Tax  Children under age 18 with unearned income greater than $2,000 are subject to kiddie tax  The unearned income in excess of $2,000 is taxed at the parent’s highest marginal tax rate  The residual taxable income is taxed at the child’s rate.  What are the kiddie tax provisions designed to prevent?

27. Wealth Transfer Tax System – Covered on last day of class.  This is an excise tax system which is different from the income tax system.  Gift, estate, and generation skipping transfer taxes  The unified gift and estate tax is based on cumulative transfers over time (life + death).  Current tax rate is 35%

28. Gift Tax  Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation.  Exclude $14,000 per year per donee from taxable gifts.  No gift tax on gifts to spouse, charity, paying tuition or medical costs.  Can treat gift by one spouse as made 1/2 by other spouse.

29. ExclusionExclusion  Lifetime exclusion  $5,340,000

30. Income Tax Effects of Gifts  Gift is not taxable income to donee.  Donor’s adjusted basis in the property carries over to become the donor’s basis.  exception - use FMV if less than adjusted basis  After gift, any income derived from the property belongs to the donee.

31. Estate Tax  Taxed at unified estate and gift rate schedule  FMV of estate is taxed  Unlimited marital deduction  Reduce estate by taxes, charity, administrative expenses.

32. Income Tax Effect of Bequests  Receipt of a bequest is not taxable income to heir.  Basis = FMV at date of death = free income tax step-up in basis. (In 2010, wealthy estates generate carryover basis).  Trade-off -  gift now at low basis, perhaps avoid some transfer tax  keep and include in estate, but heirs get high basis