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Chapter 04

Chapter 04. Individual Income Tax Overview. Learning Objectives. Describe the formula for calculating an individual’s tax liability and generally explain each formula component. Explain the requirements for determining a taxpayer’s personal and dependency exemptions.

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Chapter 04

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  1. Chapter 04 Individual Income Tax Overview

  2. Learning Objectives • Describe the formula for calculating an individual’s tax liability and generally explain each formula component. • Explain the requirements for determining a taxpayer’s personal and dependency exemptions. • Determine a taxpayer’s filing status.

  3. Individual Income Tax Formula • Realized income from whatever source derived • Minus: Excluded or deferred income • Equals: Gross income • Minus: For AGI deductions • Equals Adjusted gross income

  4. Individual Income Tax Formula • Adjusted Gross Income • Minus: From AGI deductions: • Greater of (a) Standard deduction or (b) Itemized deductions and • Personal and dependency exemption • Equals Taxable income

  5. Individual Income Tax Formula • Taxable income • Times: Tax rates • Equals: Income tax liability • Add: Other taxes • Equals: Total tax • Minus: Credits • Minus: Prepayments • Equals: Taxes due or (refund)

  6. Individual Income Tax Formula • Individuals report taxable income to the IRS • Reported on Form 1040 • U.S. tax laws use all-inclusive income concept • Realized income • measurable change in property rights • All realized income included in gross income unless specifically excluded or deferred • Recognized income • Reported on tax return

  7. Individual Income Tax Formula • Excluded income • Income never included in taxable income • Municipal bond interest • Gain on sale of personal residence • Deferred income • Income included in a subsequent tax year • Installment sales • Like-kind exchanges

  8. Individual Income Tax Formula • Character of income or loss • Determines rates applicable to income or loss in current year • Tax exempt – no tax • Tax deferred – no tax in current year • Ordinary – ordinary rates from tax rate schedule • Qualified dividends – 0 or 15% • Capital gain or loss – depends on whether short-term or long-term • From selling capital asset • If held capital asset more than a year gain or loss is long-term, otherwise it is short-term

  9. Individual Income Tax Formula • Capital assets • Generally all assets except • Accounts receivable • Inventory • Assets used in trade or business, including supplies

  10. Individual Income Tax Formula • Capital gains and losses • Long-term capital gains generally taxed at 0% or 15% • Short-term capital gains taxed at ordinary rates • Net capital losses (losses in excess of gains for year) • $3,000 deductible against ordinary income for year • Losses in excess of $3,000 carried forward

  11. Individual Income Tax Formula • Deductions for AGI • Deductions “above the line” • Deducted in determining adjusted gross income • Always reduce taxable income dollar for dollar

  12. Individual Income Tax Formula • Deductions from AGI • Deductions “below the line” • Deducted from adjusted gross income to determine taxable income • Greater of standard deduction or itemized deductions • Personal and dependency exemptions • Why might a from AGI deduction not reduce taxable income?

  13. Individual Income Tax Formula • 2011 Standard deduction amounts • $11,600 Married filing jointly • $11,600 Qualifying widow or widower • $5,800 Married filing separately • $8,500 Head of household • $5,800 Single • Additional standard deduction amounts for age and eyesight (discuss in Chapter 6)

  14. Individual Income Tax Formula • Tax calculation • The U.S. uses a progressive tax rate schedule • Some items are taxed at preferential rates • Long-term capital gains • Qualified dividends • Tax on these items is calculated separately from income taxed at ordinary rates.

  15. Individual Income Tax Formula • Other taxes include: • Alternative minimum tax • Self-employment taxes • Tax credits • Reduce tax liability dollar for dollar

  16. Individual Income Tax Formula • Tax prepayments • Payments already made towards tax liability including: • Income taxes withheld from wages by employer • Estimated tax payments made during the year • Taxes overpaid in prior year and applied toward current year’s liability • If prepayments exceed tax liability after credits, taxpayer receives a refund

  17. Personal and Dependency Exemptions • Personal exemptions • For taxpayer and spouse if married filing jointly • Dependency exemptions • For those who qualify as the taxpayers’ dependents • Exemption amount for 2011 is $3,700

  18. Personal and Dependency Exemptions • Dependency requirements • Citizen of U.S. or resident of U.S., Canada, or Mexico • Must not file joint return with spouse • Exception – if no tax liability filing jointly or separately • Must be qualifying child or qualifying relative of taxpayer

  19. Personal and Dependency Exemptions • Qualifying child • Relationship test • Age test • Residence test • Support test

  20. Qualifying Child • Relationship test • taxpayer’s son, daughter, stepchild, an eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister or a descendant of any of these relatives.

  21. Qualifying Child • Age test: child must be younger than the individual claiming the child as a qualifying child and either- • under age 19 at the end of the year, • under age 24 at the end of the year and a full-time student, or • permanently and totally disabled.

  22. Qualifying Child • Residence test • Same residence as taxpayer for more than half the year • Exception for temporary absences such as education. • Support test • Child must not provide more than half of his or her own support • Scholarships of actual child (not grandchild, for example) are excluded from support computation

  23. Qualifying Child • Tie breaking rules • Parents first • Days living with each parent if parents living apart • AGI– higher AGI gets exemption

  24. Personal and Dependency Exemptions • Qualifying relative • Relationship test • Support test • Gross income test

  25. Qualifying Relative • Relationship test • a descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent), • a sibling of the taxpayer or a stepmother, stepfather, stepbrother, stepsister, nephew, niece, aunt, uncle • in-law (mother-in law, father-in-law, sister-in-law, and brother-in-law) of the taxpayer, or • unrelated person who lives in taxpayer’s home entire year

  26. Qualifying Relative • Support test • Taxpayer must pay > ½ of living expenses (support) • Scholarships of actual child excluded • Gross income test • Gross income < personal exemption amount

  27. Filing Status • Five different filing statuses • Married filing jointly • Married filing separately • Qualifying widow or widower (surviving spouse) • Single • Head of household

  28. Filing Status • Married filing jointly • Must be married on the last day of the year • If one spouse dies the surviving spouse is considered to be married to decedent spouse at year end • Exception – The surviving spouse remarries before year end • Joint and several liability for tax

  29. Filing Status • Married filing separately • Taxpayers are married but file separate returns • Typically not beneficial from tax perspective • Tax rates and other tax benefits • May be beneficial for non-tax reasons • No joint and several liability

  30. Filing Status • Qualifying widow or widower • Available for the two years following the year of spouse’s death • Surviving spouse does not qualify if remarries during two-year period. • Surviving spouse must maintain household for dependent child

  31. Filing Status • Single • Unmarried unless qualify for head of household

  32. Filing Status • Head of household • Unmarried or considered unmarried at end of year • See abandoned spouse discussion • Not a qualifying widow or widower • Pay more than half the costs of keeping up a home during the year • Lived in taxpayer’s home with a “qualifying person” for more than half of the year • Exception for parents (see below)

  33. Filing Status • Qualifying person • Qualifying child • Qualifying relative • Parent (even if parent doesn’t live with taxpayer) • Taxpayer must pay > ½ cost of maintaining separate household for taxpayer’s mother or father • Parent must qualify as taxpayer’s dependent

  34. Filing Status • Head of household • Abandoned spouse treated as not married and is eligible for head of household if • Spouse has not lived in home for last six months of year and • Spouse who stays in home pays > ½ the cost of maintaining a household that serves as principal abode for qualifying child

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