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CCH Federal Taxation Basic Principles Chapter 3 Individual Taxation An Overview

CCH Federal Taxation Basic Principles Chapter 3 Individual Taxation An Overview. © 2003, CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 http://tax.cchgroup.com. Chapter 3 Exhibits. 1. Federal Tax Formula 2. Classification of Taxpayers

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CCH Federal Taxation Basic Principles Chapter 3 Individual Taxation An Overview

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  1. CCH Federal TaxationBasic PrinciplesChapter 3Individual TaxationAn Overview ©2003, CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL 60646-6085 800 248 3248 http://tax.cchgroup.com

  2. Chapter 3 Exhibits 1. Federal Tax Formula 2. Classification of Taxpayers 3. Filing Status 4. Computing Tax Liability 5. The Marriage Penalty 6. Effective Tax Rate vs. Marginal Tax Rate 7. Gross Income 8. Examples of “For” AGI and “From” AGI Deductions 9. Self-Employment Tax 10. Self-Employment Tax—Example 11. The Nanny Tax (for Household Employers) 12. Itemizing v. Standard Deduction Chapter 3, Exhibit Contents A CCH Federal Taxation Basic Principles

  3. Chapter 3 Exhibits 13. Itemized Deductions Phaseout 14. Personal Exemptions 15. Exemptions Phaseout 16. Credits v. Deductions 17. Tax on Kiddies’ and Other Dependents’ Income 18. Dependency Exemptions—Five Tests 19. Support Test—Example 20. Criteria for Surviving Spouse and Head of Household 21. Criteria for Abandoned Spouse Chapter 3, Exhibit Contents B CCH Federal Taxation Basic Principles

  4. Federal Tax Formula Gross Income – Deductions for Adjusted Gross Income = Adjusted Gross Income – Greater of Itemized Deductions or Standard Deduction – Personal Exemptions = Taxable Income x Tax Rate = Tax Liability + Alternative Minimum Tax (if any) – Tax Credits and Prepayments + Employment Taxes (if any) = Net Tax Due or Refund Chapter 3, Exhibit 1 CCH Federal Taxation Basic Principles

  5. Type of Return Form Individual 1040 Corporation 1120 Fiduciary 1041 Partnership 1065 Filed By Every Natural person with income of statutory minimums Corporations, including organizations taxed as corporations Trusts and estates with income in excess of statutory minimums Partnerships or joint ventures (information return only) Classification of Taxpayers Chapter 3, Exhibit 2 CCH Federal Taxation Basic Principles

  6. Filing Status • Married individuals filing jointly • Married individuals filing separate returns • Single individuals • Heads of households • Surviving spouses Chapter 3, Exhibit 3 CCH Federal Taxation Basic Principles

  7. Filing Status Computation of Taxable Income Computation of Tax Liability Federal Tax Liability Adjusted Gross Income (AGI) Standard Deduction (SD) Personal Exemption (PE) Taxable Income (TI) Single $120,000 $ 4,750 $ 3,050 $ 112,200 10% x ($6,000 – $0) = $600.00 15% x ($28,400 – $6,000) = $3,360.00 27% x ($68,800 – $28,400) = $10,908.00 30% x ($112,200 – $68,800) = $13,020 $27,888 Computing Tax Liability Chapter 3, Exhibit 4a CCH Federal Taxation Basic Principles

  8. Filing Status Computation of Taxable Income Computation of Tax Liability Federal Tax Liability Adjusted Gross Income (AGI) Standard Deduction (SD) Personal Exemption (PE) Taxable Income (TI) $22,312.50 Married Filing Jointly and Surviving Spouse $120,000 $7,950 $6,100 (2 x $3,050) $105,950 10% x ($12,000 – $0) = $1,200.00 15% x ($47,450 –$12,000) = $5,317.50 27% x ($105,950 – $47,450) = $15,795.00 Computing Tax Liability Chapter 3, Exhibit 4b CCH Federal Taxation Basic Principles

  9. Filing Status Computation of Taxable Income Computation of Tax Liability Federal Tax Liability Adjusted Gross Income (AGI) Standard Deduction (SD) Personal Exemption (PE) Taxable Income (TI) Married Filing Separately $120,000 $3,975 $3,050 $112,975 10% x ($6,000 – $0) = $600 15% x ($23,725 – $6,000) = $2,658.75 27% x ($57,325 – $23,725) = $9,072.00 30% x ($87,350 –$57,325) = $9,007.50 35% x ($112,975 – $87,350) = $8,968.75 $30,307 Computing Tax Liability Chapter 3, Exhibit 4c CCH Federal Taxation Basic Principles

  10. Computing Tax Liability Filing Status Computation of Taxable Income Computation of Tax Liability Federal Tax Liability Adjusted Gross Income (AGI) Standard Deduction (SD) Personal Exemption (PE) Taxable Income (TI) Head of Household $120,000 $7,000 $3,050 $109,950 10% x ($10,000 – $0) = $1,000.00 15% x ($38,050 – $10,000) = $4,207.50 27% x ($98,250 – $38,050) = $16,254.00 30% x ($109,950 – $98,250) = $3,510.00 $24,971.50 Chapter 3, Exhibit 4d CCH Federal Taxation Basic Principles

  11. Computing Tax Liability Observations • The Married Filing Jointly and Surviving Spouse rate schedules are identical. • For unmarried taxpayers, the filing status creating the least amount of tax liability is surviving spouse. Next in the ranking is head of household, followed by single status. Special criteria must be met to qualify for surviving spouse or head of household. • Each person who cannot be claimed as a dependent is entitled to a $3,050 personal exemption deduction. • Consider the flat tax as an alternative to the current system. Are proponents of the flat tax really championing the cause of the masses or of the wealthy? For example, joint filers with $50,000 gross income and no itemized deductions pay $4,793 or 9.6% of gross income. Who would be better off with, say, a 22% flat tax? Who would be adversely affected? Did you know that more than 70% of individual tax filers report adjusted gross income below $50,000 and claim a standard deduction? Chapter 3, Exhibit 4e CCH Federal Taxation Basic Principles

  12. The Marriage Penalty Total Taxable Income (TI) Tax Computation Federal Tax Liability Lynda and Billy are single individuals. Each earns $60,000 taxable income. What is the amount of their combined taxes? $120,000 10% x ($6,000 – $0) = $ 600.00 15% x ($28,400 – $6,000) = 3,360.00 27% x ($60,000 – $28,400) = 8,532.00 Tax on 1 single individual: $12,492.00 x 2 Tax on 2 single individuals: $24,984.00 $24,984 10% x ($12,000 – $0) = $1,200.00 15% x ($47,450 – $12,000) = $5,317.50 27% x ($114,650 – $47,450) = $18,144.00 30% x ($120,000 – $114,650) = $1,605.00 If Lynda and Billy marry and file jointly, what is the amount of their combined taxes assuming they have the same taxable income? $120,000 $26,266.50 MARRIAGE PENALTY $ 1,282.50 All things being equal, Lynda and Billy pay additional taxes of $1,282.50 solely because they choose to be married. Chapter 3, Exhibit 5 CCH Federal Taxation Basic Principles

  13. Effective Tax Rate vs. Marginal Tax Rate Effective Tax Rate • Definition. The average rate of tax paid in a tax year. • Application. Often useful when viewed retrospectively (e.g., analyzing a company’s historical after-tax cash flow). Marginal Tax Rate • Definition. The rate of tax that would apply to additional taxable income. • Application. Often useful when applied prospectively (e.g., estimating a company’s expected after-tax cash flow). Chapter 3, Exhibit 6a CCH Federal Taxation Basic Principles

  14. Effective Tax Rate vs. Marginal Tax Rate Example John-Paul files as a single individual. His taxable income is $31,000 and, based on the tax rate schedule for single individuals, his federal tax liability is $4,662. What are his effective and marginal tax rates?Solution • Effective tax rate = 15.0% ($4,662  $31,000). • Marginal tax rate = 27%. If John-Paul were to earn an additional $1 of taxable income, it would place him in the 27% bracket and the additional $1 would be subject to the 27% rate. (Refer to the tax brackets for single individuals.) Chapter 3, Exhibit 6b CCH Federal Taxation Basic Principles

  15. Gross Income Gross income includes all items of income from whatever source unless specifically excluded. Examples of gross income include compensation for services, interest, rents, royalties, dividends, and annuities. Chapter 3, Exhibit 7 CCH Federal Taxation Basic Principles

  16. Examples of “For” AGI Deductions • Capital losses up to $3,000 • Student loan interest • One-half of self-employment tax • Alimony (but not child support) • Moving expenses • Keogh and IRA deductions • 100% of medical and insurance premiums for self-employed taxpayers, their spouses, and dependents Chapter 3, Exhibit 8a CCH Federal Taxation Basic Principles

  17. Examples of “For” AGI Deductions Chapter 3, Exhibit 8b CCH Federal Taxation Basic Principles

  18. Examples of “From” AGI Deductions • Medical expenses • exceeding 7.5% AGI floor • not business related • Property taxes • state and local, not federal • on principal residences, personal-use cars, stock, and other nonbusiness-use property • Income taxes • state and local, not federal • on salaries, capital gains, and other nonbusiness income Chapter 3, Exhibit 8c CCH Federal Taxation Basic Principles

  19. Examples of “From” AGI Deductions • Interest on home mortgages (including home equity loans) • Casualty losses • exceeding 10% AGI floor • on principal residences, personal-use cars, and other personal-use property • Charitable contributions • not to exceed50% AGI ceiling • in certain cases, not to exceed 30% or 20% ceiling Chapter 3, Exhibit 8d CCH Federal Taxation Basic Principles

  20. Examples of “From” AGI Deductions • Most miscellaneous itemized deductions but only the aggregate amount exceeding 2% AGI floor Examples: Þ  unreimbursed employee business expenses Þ  hobby expenses (out-of-pocket and depreciation) Þ  tax preparation fees Þ  investment counseling fees Exception: Þ  gambling losses are NOT subject to the 2% AGI floor Chapter 3, Exhibit 8e CCH Federal Taxation Basic Principles

  21. Self-Employment Tax The tax rate is 15.3%, made up of two parts: • an old-age, survivors, and disability insurance (OASDI) rate of 12.4% • a medicare hospital insurance (HI) rate of 2.9% Chapter 3, Exhibit 9 CCH Federal Taxation Basic Principles

  22. Computing net self-employment earnings Gross income from self-employment Business deductions Self-employment earnings (i.e., Schedule C amount) "Pretend" deduction Net self-employment earnings (a) (b) (c) = (a) – (b) (d) = (c) x 7.65% (e) = (c) – (d) $146,000 $30,000 $146,000 – $30,000 = $116,000 $116,000 x 7.65% = $8,874 $116,000 – $8,874 = $107,126 Computing OASDI limit (f) (g) = $87,000 – (f) Salary from employer OASDI limit, adjusted $49,300 $87,000 – $49,300 = $37,700 Self-Employment Tax—Example Chapter 3, Exhibit 10a CCH Federal Taxation Basic Principles

  23. Computing OASDI tax (h) = lesser of (e) or (g) (i) (j) = (h) x (i) OASDI base OASDI tax rate OASDI tax $37,700 12.4% $37,700 x 12.4% = $4,674.80 Computing Medicare tax (k) = (e) (l) (m) = (k) x (l) (n) = (j) + (m) (o) = (n) x 1/2 Net earnings Medicare tax rate Medicare tax Total FICA tax = OASDI + Medicare FICA tax deduction "for" AGI $107,126 2.9% $107,126 x 2.9% = $3,107 $4,674.80 + $3,107 = $7,781.80 $7,781.80 x 1/2 = $3,890.90 Self-Employment Tax—Example Chapter 3, Exhibit 10b CCH Federal Taxation Basic Principles

  24. The Nanny Tax (for Household Employers) Chapter 3, Exhibit 11a CCH Federal Taxation Basic Principles

  25. The Nanny Tax (for Household Employers) Chapter 3, Exhibit 11b CCH Federal Taxation Basic Principles

  26. Itemizing v. Standard Deduction Itemized deductions are certain expenses of a personal nature that are specifically allowed as a deduction. Taxpayers receive the minimum amount of itemized deductions called the standard deduction. All taxpayers subtract the larger of their itemized deductions or the standard deduction. Chapter 3, Exhibit 12 CCH Federal Taxation Basic Principles

  27. Itemized Deductions Phaseout  of ID’s (except “MICG”) = the lesser of (a) or (b):   (a)     = (AGI - TH) x 3%; or    (b)     = 80% of total non-MICG’s Chapter 3, Exhibit 13a CCH Federal Taxation Basic Principles

  28. Itemized Deductions Phaseout Chapter 3, Exhibit 13b CCH Federal Taxation Basic Principles

  29. Personal Exemptions In computing taxable income, an individual is allowed a deduction for each personal exemption allowed. Such exemptions are (1) the exemptions for an individual taxpayer and spouse, and (2) the exemptions for dependents of the taxpayer. No personal exemption is allowed on the return of an individual who is eligible to be claimed as a dependent on another taxpayer’s return. Chapter 3, Exhibit 14 CCH Federal Taxation Basic Principles

  30. Exemptions Phaseout%  of PDE’s = (AGI - TH)  $2,500 (or $1,250 if MFS)rounded upward, x 2, expressed as a %where, ·  “%  of PDE’s” means “percentage of personal and dependency exemptions to be reduced.”·  “TH” = Threshold Amount of: Chapter 3, Exhibit 15 CCH Federal Taxation Basic Principles

  31. Credits v. Deductions • Credit—directly reduces the tax liability. • Deduction—reduces income to which the rate applies and indirectly reduces the tax liability. Chapter 3, Exhibit 16 CCH Federal Taxation Basic Principles

  32. Tax On Kiddies’ and Other Dependents’ Income Chapter 3, Exhibit 17a CCH Federal Taxation Basic Principles

  33. Tax On Kiddies’ and Other Dependents’ Income Chapter 3, Exhibit 17b CCH Federal Taxation Basic Principles

  34. Tax On Kiddies’ and Other Dependents’ Income Chapter 3, Exhibit 17c CCH Federal Taxation Basic Principles

  35. Dependency Exemptions—Five Tests 1. SUPPORT TEST. A taxpayer must provide over one-half of the amount “actually spent” (NOT “over one-half of the amount available for support”) on the potential dependent. Chapter 3, Exhibit 18a CCH Federal Taxation Basic Principles

  36. Dependency Exemptions—Five Tests 2. RELATIONSHIP/HOUSEHOLD TEST. Either of the following must be satisfied. Relationship test: Dependent must be a relative. Aunts and uncles qualify, first cousins do not. Household test: Dependent must occupy the taxpayer’s household during the entire year (exceptions include birth, death, illness, education, business travel, vacation, and military service). Chapter 3, Exhibit 18b CCH Federal Taxation Basic Principles

  37. Dependency Exemptions—Five Tests 3. GROSS INCOME TEST. Any one of the following conditions must be present. • Dependent’s gross income < $3,050 in 2003 • Dependent’s gross income  $3,050 in 2003 and dependent is both under the age of 19 and a child of the taxpayer • Dependent’s gross income  $3,050 in 2003 and dependent is under the age of 24, a child of the taxpayer, and a full-time student. Chapter 3, Exhibit 18c CCH Federal Taxation Basic Principles

  38. Dependency Exemptions—Five Tests 4. CITIZEN OR RESIDENT ALIEN TEST. Dependent must be a citizen or national of the United States, or dependent must reside in the United States, Canada, Mexico, or American Samoa. Chapter 3, Exhibit 18d CCH Federal Taxation Basic Principles

  39. Dependency Exemptions—Five Tests 5. RETURN TEST. Dependent does not file a joint return, or dependent files a joint return solely to claim a refund. Chapter 3, Exhibit 18e CCH Federal Taxation Basic Principles

  40. Support Test—Example Chapter 3, Exhibit 19 CCH Federal Taxation Basic Principles

  41. Criteria for Surviving Spouse and Head of Household Chapter 3, Exhibit 20 CCH Federal Taxation Basic Principles

  42. Criteria for Abandoned Spouse Abandoned spouse tax rates are the same as heads of household if four criteria are met: • Cost of household furnished by taxpayer exceeds one-half of the total cost. • Abode of the taxpayer is the abode of a dependent child over one-half of the year. • Time away of “two-timer” > 6 months. • Separate return is filed. Chapter 3, Exhibit 21 CCH Federal Taxation Basic Principles

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