CHAPTER 1

1. CHAPTER 1 The Individual Income Tax Return Income Tax Fundamentals 2007 edition Gerald E. Whittenburg & Martha Altus-Buller

2. Objectives of Tax Law • Raise revenue • Tool for social and economic policies • Social policy encourages desirable activities and discourages undesirable activities • Can’t deduct penalties • Can deduct charitable contributions • Economic policy as manifested by fiscal policy • Encourage investment in capital assets by accelerating depreciation • Both economic and social • Exclude gain on sale of personal residence up to $250,000 [$500,000 if married]

3. Primary Entities/Forms • Individuals • Taxable income includes wages, salary, self-employment earnings, rent, interest and dividends • An individual may file the simplest tax form that he/she qualifies for • 1040EZ • 1040A • 1040

4. Tax Formula for Individuals This follows form 1040 Gross Income less: Deductions for Adjusted Gross Income [AGI] AGI less: Greater of Itemized or Standard Deduction less: Exemptions Taxable Income times: Tax Rate Gross Tax Liability less: Tax Credits and Prepayments equals: Tax Due or Refund

5. Filing Status • Single • Unmarried or legally separated as of 12/31 • Married Filing Jointly [MFJ] • If married on 12/31 - if spouse dies during year you can file MFJ • Married Filing Separately [MFS] • Each file separate returns • Must compute taxes the same way - both itemize or use standard • If living in community property state, must follow state law to determine community and separate income • Head of Household [HOH] • Taxpayer can use file as HOH if unmarried as of 12/31and paid > 50% of cost of keeping up home that was principal residence of dependent • Surviving Spouse - Qualifying Widow[er] • Applies in year of spouse’s death and in two subsequent years • Must pay over ½ price of maintaining a household with a dependent child

6. Standard Deductions & Exemption • 2006 standard deductions • Single $ 5,150 • Married Filing Joint [MFJ] $10,300 • Surviving Spouse [SS] $10,300 • Head of Household [HOH] $ 7,550 • Married Filing Separate [MFS] $ 5,150 *Taxpayers 65 or older and/or blind get an additional amount • $1000 if MFJ, MFS or SS • $1250 if HOH or Single • 2006 exemption$3300 per person

7. Standard Deduction - Dependents The special rule for standard deduction for dependents is “deduction = greater of $850 or earned income + $300 but only up to basic standard deduction” Example 1: Jaime is 23 and a full time student and her folks claim her as a dependent; she earned $2,000 in 2006. 2,000 earned income (2,000) standard deduction $0 taxable income Example 2: Tia is 18 and has dividend income [not earned] of $1,500 1,500 dividend income ( 850) standard deduction $ 650 taxable income

8. Itemized Deductions • Use itemized deductions if they exceed standard deduction • Phased out for high income taxpayers • 2% x (AGI - Threshold Amount) • Threshold amount • $ 75,250 for MFSor • $150,500 (all other filing types) • Phase-out calculation • (AGI – Threshold Amount) x 2% but limited to • 80% x all itemized deductions except medical, investment interest expense, casualty losses and wagering losses

9. Personal/Dependency Exemptions • For taxpayer and each dependent - $3,300 per person • Phased out for high income taxpayers • 2% per $2,500 [$1250 if MFS] over threshold • See p. 1-14 for limits based on filing status • Phase out limited to 2/3 of exemption amount

10. Capital Gains/Losses • A capital asset is any property [personal or investment] held by a taxpayer, with certain exceptions as listed in the tax law • Gains/losses on these assets are subject to special rates • Holding period of asset determines treatment • Long term - held >12 months (taxed at capital rates) • Short term - held <= 12 months (taxed at ordinary rates)