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Tax Formula and Income Determination: An Overview

Explore the fundamentals of income taxation, property transactions, and tax deductions in this comprehensive overview. Learn about gross income, exclusions, deductions for AGI, and more to understand the tax formula concept.

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Tax Formula and Income Determination: An Overview

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  1. Chapter 3 Tax Formula and Tax Determination; An Overview of Property Transactions

  2. The Big Picture (slide 1 of 2) Polly maintains a household in which she lives with her Unemployed husband (Nick), Stepdaughter (Paige), and A family friend (Maude). She provides more > ½ the support of both Paige and Maude. Maude was fatally injured in an automobile accident in February Polly paid for her hospitalization and funeral expenses. Paige, an accomplished gymnast, graduated from high school last year. Paige has a part-time job but spends most of her time training and looking for an athletic scholarship to the ‘‘right’’ college. 2

  3. The Big Picture (slide 2 of 2) In March, Nick left for parts unknown and has not been seen or heard from since. Polly sold her wedding rings to a cousin who was getting married. The rings cost $11,800. The rings were sold for their approximate value of $9,000. Based on these facts, what are Polly’s income tax concerns for the current year? Read the chapter and formulate your response. 3

  4. Tax Formula Concept Summary 3.1

  5. Income -Broadly Conceived • Includes all the taxpayer’s income, both taxable and nontaxable • Essentially equivalent to gross receipts • It does not include a return of capital or receipt of borrowed funds

  6. Accident insurance proceeds Annuities (cost element) Bequests Child support payments Cost-of-living allowance (for military) Damages for personal injury or sickness Gifts received Group term life insurance, premium paid by employer (for coverage up to $50,000) Inheritances Interest from state and local (i.e., municipal) bonds Life insurance paid on death Meals and lodging (if furnished for employer’s convenience) Military allowances Minister’s dwelling rental value allowance Railroad retirement benefits (to a limited extent) Scholarship grants (to a limited extent) Social Security benefits (to a limited extent) Unemployment compensation (to a limited extent) Veterans’ benefits Welfare payments Workers’ compensation benefits Partial List of Exclusions from Gross Income Exhibit 3.1

  7. Gross Income • The Internal Revenue Code defines gross income broadly as ‘‘except as otherwise provided . . . , all income from whatever source derived’’ • Gross income does not include unrealized gains

  8. Alimony Annuities (income element) Awards Back pay Bargain purchase from employer Bonuses Breach of contract damages Business income Clergy fees Commissions Compensation for services Death benefits Debts forgiven Director’s fees Dividends Embezzled funds Employee awards (in certain cases) Employee benefits (except certain fringe benefits) Estate and trust income Farm income Fees Gains from illegal activities Gains from sale of property Gambling winnings Group term life insurance, premium paid by employer (for coverage over $50,000) Partial List of Gross Income Items (slide 1 of 2) Exhibit 3.2

  9. Hobby income Interest Jury duty fees Living quarters, meals (unless furnished for employer’s convenience) Mileage allowance Military pay (unless combat pay) Notary fees Partnership income Pensions Prizes Professional fees Punitive damages Rents Rewards Royalties Salaries Severance pay Strike and lockout benefits Supplemental unemployment benefits Tips and gratuities Travel allowance (in certain cases) Treasure trove (found property) Wages Partial List of Gross Income Items (slide 2 of 2) Exhibit 3.2

  10. Deductions - Individual Taxpayers • Individual taxpayers have two categories of deductions: • Deductions for adjusted gross income (AGI) • Deductions from adjusted gross income

  11. Deductions For AGI (slide 1 of 2) • Sometimes known as above-the-line deductions • On the tax return, they are taken before the ‘‘line’’ designating AGI

  12. Deductions For AGI (slide 2 of 2) • Deductions for AGI include: • Ordinary and necessary expenses incurred in a trade or business • One-half of self-employment tax paid • Alimony paid • Certain payments to an IRA and Health Savings Accounts • Unreimbursed moving expenses • Fees for college tuition and related expenses • Interest on student loans • The capital loss deduction, and • Others

  13. Adjusted Gross Income (AGI) • AGI is an important subtotal • Serves as the basis for computing percentage limitations on certain itemized deductions such as • Medical expenses • Charitable contributions • Certain casualty losses • e.g., Medical expenses are deductible only to the extent they exceed 10% of AGI (7.5% if ≥ age 65) • This limitation might be described as a 10% “floor” under the medical expense deduction

  14. Deductions From AGI (slide 1 of 3) • Deductions from AGI include: • The greater of: • Itemized deductions, or • The standard deduction • Personal and dependency exemptions

  15. Deductions From AGI (slide 2 of 3) • A partial list of itemized deductions includes: • Medical expenses (in excess of 10% of AGI) • In excess of 7.5% if ≥ age 65 • Certain taxes and interest • Charitable contributions • Casualty Losses (in excess of 10% of AGI) • Deductions for expenses related to • The production or collection of income, and • The management of property held for the production of income • Certain miscellaneous itemized deductions (in excess of 2% of AGI)

  16. Deductions From AGI (slide 3 of 3) • The standard deduction is the sum of two components: • Basic standard deduction • Amount allowed is based on taxpayer’s filing status • Additional standard deductions • Available for taxpayers who are • Age 65 or over, and/or • Blind • Two additional standard deductions are allowed for a taxpayer who is age 65 or over and blind • Amount allowed depends on filing status

  17. Standard Deduction (slide 1 of 2) • The basic standard deduction (BSD) amount depends on filing status of taxpayer EXHIBIT 3.4

  18. Standard Deduction (slide 2 of 2) • Additional standard deduction (ASD) • For taxpayers age 65 or older and/or legally blind EXHIBIT 3.5

  19. Determining Standard Deduction • Examples (2015 tax year): • Taxpayer is single, blind, and age 65 or older • SD = $6,300 (BSD) + $1,550 (ASD) + $1,550 (ASD) = $9,400 • Taxpayers are married, filing jointly, one blind, and both age 65 or older • SD = $12,600 (BSD) + $1,250 (ASD) + $1,250 (ASD) + $1,250 (ASD) = $16,350

  20. Taxpayers Ineligible For Standard Deduction • Certain taxpayers cannot use the SD: • Married, filing separately, when either spouse itemizes deductions • Nonresident aliens • Individual filing return for tax year of less than 12 months because of change in annual accounting period

  21. SD Limit For Person Claimed as Dependent • Individual claimed as dependent has a BSD in 2015 limited to the greater of: • $1,050 or • $350 plus earned income (but not exceeding normal BSD) • ASD amount(s) still available

  22. Examples of SD Limit (slide 1 of 2) • Dependent’s SD (2015 tax year): • A blind child who earns $200 and is claimed by parents as a dependency exemption • SD = $1,050 (BSD) + $1,550 (ASD) = $2,600 • A child who earns $1,500 and is claimed by parents as a dependency exemption • SD = $1,850 [BSD equal to greater of $1,050 or ($350 + $1,500 earned income)]

  23. Examples of SD Limit (slide 2 of 2) • Examples of dependent’s SD (2015 tax year) • A child who earns $6,100 and is claimed by parents as a dependency exemption • SD = $6,300 [BSD equal to greater of $1,050 or ($350 + $6,100 earned income) limited to the $6,300 standard deduction for a single taxpayer]

  24. Personal and DependencyExemption Amounts • Amounts • 2015: $4,000 per exemption • 2014: $3,950 per exemption • Personal and dependency exemptions • One per taxpayer (two personal exemptions when married, filing jointly) and for each dependent • Exception: Individual claimed as dependent by another taxpayer does not receive a personal exemption

  25. Personal and Dependency Exemptions In Year Of Death • Personal exemption allowed on joint return for spouse who dies during the year • Example: Tom and Betty were married in 1990. Tom dies on February 1, 2015. A personal exemption may be claimed for Tom on the taxpayers’ 2015 joint return.

  26. Dependency Exemptions (slide 1 of 2) • A dependency exemption is available for one who is either a qualifying child or a qualifying relative • A qualifying child must meet the following tests: • Relationship • Abode • Age, and • Support

  27. Dependency Exemptions (slide 2 of 2) • Congress has tried to establish a uniform definition of qualifying child for purposes of the: • Dependency exemption • Head-of-household filing status • Earned income tax credit • Child tax credit • Credit for child and dependent care expenses

  28. Relationship Test • The child must be the taxpayer’s: • Son or daughter • Stepson or stepdaughter • Brother or sister • Stepbrother or stepsister • Half brother or half sister, or • A descendant of such individual (e.g., grandchildren, nephews, nieces) • A child who has been adopted, or whose adoption is pending, qualifies • A foster child may also qualify

  29. Abode Test • A qualifying child must live with the taxpayer for more than half of the year • Temporary absences from the household due to special circumstances (e.g., illness, education) are not considered

  30. Age Test • The child must be under age 19 or under age 24 in the case of a student • A student is a child who, during any part of five months of the year, is enrolled full time at a school or government-sponsored on-farm training course • Individuals who are disabled are not subject to the age test

  31. The Big Picture - Example 14Dependency Exemptions Return to the facts of The Big Picture on p. 3-1. Does Paige meet the requirements of a qualifying child so Polly can claim a dependency exemption for her? Paige satisfies the relationship and abodetests, but the answer to the age test remains unclear. Since she is not a full-time student or disabled, she must be under 19 to meet the age test. Unfortunately, the facts given do not provide Paige’s precise age. 31

  32. Support • To be a qualifying child, the individual must not be self-supporting • Cannot provide more than one-half of his or her own support • In the case of a full-time student, scholarships are not considered to be support

  33. Tiebreaker Rules • In situations where a child may be a qualifying child for more than one person • Tiebreaker rules specify which person has priority in claiming the dependency exemption Concept Summary 3.2

  34. Qualifying Relative • In order to claim a dependency exemption for a qualifying relative, the following tests must be met: • Relationship • Gross income • Support

  35. Relationship Test • The relationship test for a qualifying relative is more expansive than for a qualifying child. Also included are the following relatives: • Lineal ascendants (e.g., parents, grandparents) • Collateral ascendants (e.g., uncles, aunts) • Certain in-laws (e.g., son-, daughter-, father-, mother-, brother-, and sister-in-law) • The relationship test also includes unrelated parties who live with the taxpayer

  36. The Big Picture - Example 19Dependency Exemptions Return to the facts of The Big Picture on p. 3-1. Is Maude a qualifying relative? Although Maude is unrelated to Polly, she qualifies as Polly’s dependent by being a member of the household. Since Maude is a dependent, Polly can also claim the medical expenses she paid on Maude’s behalf. The funeral expenses are not deductible. Although Maude lived for only two months, the full amount of the dependency exemption is allowed and does not have to be apportioned. 36

  37. Gross Income Test • Dependent’s gross income must be less than the exemption amount ($4,000 for 2015)

  38. The Big Picture - Example 22Dependency Exemptions Return to the facts of The Big Picture on p. 3-1. Assuming that Paige is not a qualifying child, can she be a qualifying relative for dependency exemption purposes? She meets the relationship and support tests, but what about the gross income test? If her income from her part-time job is less than $4,000, she does qualify and can be claimed by Polly as a dependent. 38

  39. Support Test • Taxpayer must provide more than 50% of the qualifying relative’s support • Only amounts expended are considered in the support test • Scholarships are not considered in the support test • Two exceptions to the support test: • Multiple support agreements • Children of divorced parents

  40. Multiple Support Agreements • Allows one member of a group providing > 50% of support to claim individual even though no one person provides > 50% support • Eligible parties must provide > 10% of support • Each eligible party must meet all other dependency requirements • Example - Allows children of elderly parent to claim exemption for parent when none individually meets the 50% support test

  41. Children of Divorced Parents • Special rules apply if the parents meet the following conditions: • They would have been entitled to the dependency exemption had they been married and filed a joint return • They have custody (either jointly or singly) of the child for more than half of the year • Under the general rule, the parent having custody of the child for the greater part of the year (i.e., the custodial parent) is entitled to the dependency exemption • General rule does not apply if • A multiple support agreement is in effect • Custodial parent issues a waiver in favor of the noncustodial parent

  42. Other Rules for Dependency Exemptions • In addition to fitting into either the qualifying child or the qualifying relative category, a dependent must also meet: • The joint return, and • The citizenship or residency tests

  43. Joint Return Test • Dependent cannot file a joint return with spouse unless: • Filing solely for refund of tax withheld • No tax liability exists for either spouse • Neither spouse required to file return

  44. Citizenship or Residency Test • Dependent must be a U.S. citizen or a resident of U.S., Canada, or Mexico for some part of the calendar year in which the taxpayer’s tax year begins • An exception provides that an adopted child need not be a citizen or resident of the U.S. (or a contiguous country) as long as his or her principal abode is with a U.S. citizen

  45. Phaseout of Exemptions • Personal and dependency exemptions are phased out by 2% for each $2,500 (or fraction thereof) by which the taxpayer’s AGI exceeds the following threshold amounts • For a married taxpayer filing separately, the phaseout is 2% for each $1,250 (or fraction thereof)

  46. Child Tax Credit • $1,000 tax credit is allowed for each dependent child under the age of 17 • Qualifying child includes stepchildren and eligible foster children

  47. Filing Requirements (slide 1 of 2) • General Rule: Tax return must be filed if gross income is ≥ the sum of the standard deduction and exemption amount • ASD for blind does not apply for this determination • Special rules apply for dependents and self-employed taxpayers

  48. Filing Requirements (slide 2 of 2) • Tax return of an individual is due on or before the 15th day of the 4th month after taxpayer’s year end • Most individuals are calendar year taxpayers, thus, due date is April 15 • May obtain a 6 month extension of time to file • Excuses a taxpayer from penalty for failure to file, not from penalty for failure to pay • If more tax is owed, extension request (Form 4868) should be accompanied by check for balance of tax due

  49. Filing Status • There are 5 filing statuses • Single • Married, filing jointly • Surviving spouse (qualifying widow or widower) • Head of household • Married, filing separately • Filing status affects tax rate brackets, standard deduction, and other amounts

  50. Single Filing Status • Includes a taxpayer who is unmarried or separated from spouse by a divorce decree or separate maintenance agreement and does not qualify for another filing status • Marital status is determined as of the last day of the tax year • When a spouse dies during the year, marital status is determined as of the date of death

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