Chapter 14

1. Chapter 14 The Individual Tax Formula

2. Objectives • Filing status • Computing taxable income • Standard deduction versus itemized deductions • Exemptions • Tax rates • Marriage penalty • Child credit and dependent care credit • Individual AMT • Payment and filing requirements

3. Filing Status • Filing status • Reflects an individual’s marital and family situation • Affects the calculation of taxable income • Determines the rates at which income is taxed

4. Filing Status - Married • MFJ or MFS if married on the last day of the year • MFJ (married filing joint) rates • If spouse incomes are very 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 may file as Surviving Spouse • MFS (married filing separately) rates are less favorable than single

5. Filing Status - Unmarried • The 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

6. Filing Status Examples • Application Problem 1 • Mr. J and Mrs. J were legally divorced on November 18. Mr. J has not remarried and has no dependent children. • Mr. J and the first Mrs. J were legally 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, 2005. Mr. J has not remarried and maintains a home for one dependent child.

7. Application Problem 1 (continued) • Mrs. J died on May 30, 2006. Mr. J has not remarried and has no dependent children. • Mr. J and Mrs. J were legally divorced on May 30, 2004. Mr. J has not remarried and maintains a home for his two dependent children.

8. Taxable Income Computation • Step One: Calculate total income on Line 22 on Form 1040 • Step Two: Calculate Adjusted Gross Income (AGI) on Line 34 of Form 1040 • Step Three: Subtract the greater of itemized deductions or the standard deduction • Step Four: Subtract total exemptions

9. Step One • Taxable income includes • Business income • Salary or wage payments • Investment income

10. Step Two • Adjusted Gross Income (AGI) equals total income less specific above-the-line deductions • AGI is an extremely important number as many individual deductions and credits are limited byreference to a taxpayer’s AGI

11. Step Three • Subtract the greater of • The standard deduction • Or allowable itemized deductions

12. Standard Deduction • Depends on filing status. For 2007 • MFJ = $10,700 • MFS = $5,350 • HOH = $7,850 • Single = $5,350 • Blind or aged (>=age 65) • MJF, MFS = additional $1,050 • HOH or Single = additional $1,300 • Ben, age 65, and Mary, age 64, are married filing joint. What is their 2007 standard deduction? • $10,700 + $1,050 = $11,750

13. Itemized Deductions • See Schedule A (Chapter 17 details) • Only 30% of individual filers elect to itemize their deductions • Bunching: if itemized deductions are about equal to standard deduction each year, the taxpayer should bunch deductions on alternate years and claim standard deduction on other years

14. Bunching Example • My dad gives $5,000 to charity each year. He is 77 and single. What is his standard deduction each year? • $5,350 + 1, 300 = $6,650 • Does he itemize? • No, as the standard deduction of $6,650 is greater than itemized deductions of $5,000 • Suppose he gave $10,000 to the church every other year? • He would benefit by taking a $10,000 itemized deduction in the years of the charitable contribution and taking the standard deduction in the other years

15. Key Observation re: Individual Tax Deductions • A deduction listed as an above-the-line deduction always reduces taxable income • A deduction that must be itemized may have limited or even no effect on taxable income • The classification as either above-the-line or itemized deductions often reflects tax policy concerns and can change from year to year

16. Step Four • Subtract exemption amounts • The taxpayer is allowed a personal exemption • Two exemptions are allowed if Married Filing Joint • If you are a dependent on someone else’s return, can you still claim an exemption for yourself? No! • The exemption amount is $3,400 for 2007 for each personal and dependency exemption

17. Exemptions for Dependents • If an individual passes all five tests, you may claim him or her as a dependent • Family member OR live in your home for entire year • You provide > 1/2 financial support • Dependent’s gross income < exemption amount of $3,400 in 2007 • Waived for child < 19 years OR student-child<24 years • Dependent may not generally file a joint return • Dependent must be a U.S. citizen OR a resident of US, Mexico, or Canada

18. Application Problem 3 • Mr. and Mrs. O file a joint income tax return. Determine if they can claim a personal exemption for any of the following individuals • Son Jack, age 20, who lives in his parents’ home and works full time as an auto mechanic. Jack is self-supporting except for the fact that he does not pay rent to his parents. • Daughter Brenda, age 22, who is a full-time college student. Brenda lives in a dormitory during the school year but her parents’ home is her permanent residence, and her parents provide 100 percent of her financial support.

19. Application Problem 3 (continued) • Nephew Eddie, age 16, who has lived in Mr. and Mrs. O’s home since 2003. Eddie is a high school student who earned $6,690 this summer working for a plumber. Since his aunt and uncle provide 100 percent of his financial support, Eddie is saving his earnings for college. • Mr. O’s mother Mildred, age 64, who lives in a retirement community. Mr. and Mrs. O provide about 65 percent of her financial support. Mildred earned $4,650 this year as a part-time librarian. • Mrs. O’s father Richard, age 76, who has lived in Mr. and Mrs. O’s home since 2000. Mr. and Mrs. O provide about 30 percent of his financial support. The rest of his support comes from Social Security.

20. High-income Taxpayers • Phase-out of itemized deductions - If AGI > $156,400 (MFJ) in 2007, itemized deductions are reduced by 2% of income > $156,500. Can’t reduce itemized deductions below 20% of total • Phase-out of exemptions - IF AGI > $234,600 (MFJ) in 2007, reduce exemption by 1 and 1/3% for each $2500 of AGI above the threshold. Can reduce to $0 • See appendices 14A and B for computations. Phase outs scheduled to be eliminated gradually starting 2006

21. The Four-step Procedure • Summarized as follows • Total Income • Less: Above-the-line deductions • Equals: Adjusted Gross Income (AGI) • Less: Standard Deduction or Itemized Deductions • Less: Personal Exemption amounts • Equals: Taxable Income

22. Tax Computations • Calculate the tax liability for each of the following using the tax rate schedule • Taxable income of $85,000, MFJ status • $8772.50 + .25 ($85,000 - $63,700) = $14,098 • Taxable income of $120,000, Single status • $15,698.75 + .28 ($120,000 - $77,100) = $27,711

23. The Marriage Penalty Dilemma • The federal income tax system is not marriage neutral • Congress has provided some limited relief for lower income taxpayers • 10 & 15% brackets are exactly twice that for single taxpayers • Standard deduction for married couples is exactly twice that for single taxpayers • A progressive tax system that allows married couples to file joint returns can be marriage neutral or horizontally equitable – but not both!

24. Credits • Child Credit = $1,000 per child under age 17 as of Dec. 31. Phases out for high-income taxpayers • Dependent care credit for children < 13 years old or a dependent who is physically or mentally incapable of caring for themselves. Credit amount is between 30% and 20% of child care costs depending on income range

25. Credits • Earned income credit is refundable - a transfer payment to working poor that increases progressivity of tax rates • Credit is higher for taxpayers with children and phases out as income increases • Maximum credit in 2007 is $4,716 for households with two or more children • Excess FICA withholding is refunded through a tax return claim

26. AMT (again!!) • Why do we need AMT? • To guarantee that high-income taxpayers who dramatically reduced their regular tax by overindulging in tax preferences will still pay a fair share of income tax • More and more middle-income taxpayers with modest amounts of AMT adjustments or preferences are having to pay AMT

27. AMT (again!!) • Middle-income taxpayers are being subjected to AMT because regular income tax rates are adjusted for inflation annually while AMT rates are not • Unless Congress makes major changes, the AMT will affect 33 million individuals by 2010

28. AMT • Taxable income+/– adj. (e.g. standard deduction or exemption amounts) • + preferences= AMTI before exemption- exemption ($62,550 MFJ, phases out for rich)= AMTIx 26% (or 28% for higher AMTI levels)= TMT

29. Payment and Filing Requirements • Taxes on wages are withheld each pay period • Estimated taxes on self-employment income are due on April 15, June 15, September 15, and January 15

30. Payment and Filing Requirements • An underpayment penalty can be avoided by paying 90% of current year tax, 100% of prior year (or 110% of prior year if AGI>$150,000) • Tax return due 4/15; the filing of the return (not the payment of the taxes) may be extended to 8/15 then 10/15 (LAST DATE)