Understanding Individual Income Tax Formulas and Deductions

1. Chapter 4 Individual Income Tax Overview, Exemptions, and Filing Status

2. Learning Objectives • Describe the formula for calculating an individual taxpayer's taxes payable or refund 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. The Individual Income Tax Formula Gross income • Minus: For AGI deductions • Equals: Adjusted gross income • Minus: From AGI deductions: • Greater of (a) Standard deduction or (b) Itemized deductions and • Personal and dependency exemption • Equals: Taxable income

4. The Individual Income Tax Formula (2) Taxable income • Times: Tax rates • Equals: Income tax liability • Plus: Other taxes • Equals: Total tax • Minus: Credits • Minus: Prepayments • Equals: Taxes due or (refund)

5. The Individual Income Tax Formula (3) • 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

6. The Individual Income Tax Formula (4) • Excluded and deferred income not included in gross income • 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

7. The Individual Income Tax Formula (5) • 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 (current year tax rate is zero) • Ordinary – ordinary rates from tax rate schedule • Qualified dividends taxed at 0%, 15%, or 20% depending on taxpayer’s income level • 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 • Net long-term gains taxed at preferential rates

8. The Individual Income Tax Formula (6) • Capital assets • Generally all assets except • Accounts receivable • Inventory • Assets used in trade or business, including supplies

9. The Individual Income Tax Formula (7) • Capital gains and losses • Net long-term capital gains in excess of net short-term capital losses are generally taxed at 0%, 15%, or 20% depending on the taxpayer’s taxable income • 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

10. The Individual Income Tax Formula (8) • Deductions for AGI • “Deductions above the line” • Deducted in determining adjusted gross income • Always reduce taxable income dollar for dollar

11. The Individual Income Tax Formula (9) • 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?

12. The Individual Income Tax Formula (10) • 2017 standard deduction amounts • $12,700 Married filing jointly • $12,700 Qualifying widow or widower • $6,350 Married filing separately • $9,350 Head of household • $6,350 Single • Additional standard deduction amounts for age and eyesight (discuss in Chapter 6)

13. The Individual Income Tax Formula (11) • 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

14. The Individual Income Tax Formula (12) • Other taxes include: • Alternative minimum tax • Self-employment taxes • 3.8% net investment income tax • .9% additional Medicare tax • Tax credits • Reduce tax liability dollar for dollar

15. The Individual Income Tax Formula (13) • Tax prepayments • Payments already made toward 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

16. Personal and Dependency Exemptions • Personal exemptions • For taxpayer and spouse if married filing jointly • Dependency exemptions • For each person who qualifies as the taxpayer’s dependent • Exemption amount for 2017 is $4,050

17. Personal and Dependency Exemptions (2) • 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

18. Personal and Dependency Exemptions (3) • Qualifying child • Relationship test • Age test • Residence test • Support test

19. 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

20. Qualifying Child (2) • 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

21. Qualifying Child (3) • 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

22. Qualifying Child Example Rodney and Anita have two children: Braxton, age 12, who lives at home, and Tara, age 21, who is a full-time student and does not live at home. While Tara earned $9,000 in a summer job, she did not provide more than half of her own support during the year. Are Braxton and Tara qualifying children of Rodney and Anita?

23. Qualifying Child Example Solution

24. Qualifying Child (4) • Tiebreaking rules • Parents first • Days living with each parent if parents living apart • AGI – higher AGI gets exemption

25. Qualifying Child Example (2) Braxton’s uncle Shawn (Rodney’s brother) lived in the Halls’ home (the same home Braxton lived in) for more than 11 months during the year. Does Braxton meet the requirements to be considered Shawn’s qualifying child?

26. Qualifying Child Example Solution (2)

27. Qualifying Child Example (3) Braxton is considered to be Rodney and Anita’s qualifying child and he is considered to be Shawn’s qualifying child. Under the tiebreaker rules, who is allowed to claim Braxton as a dependent for the year?

28. Qualifying Child Example Solution (3) Answer: Rodney and Anita. Under the first tiebreaking rule, Rodney and Anita are allowed to claim the dependency exemption for Braxton because they are Braxton’s parents.

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

30. Qualifying Relative • Relationship test • A descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent), • A sibling of the taxpayer including a stepbrother or stepsister • A son or daughter of the taxpayer’s brother or sister (not cousins) • A sibling of the taxpayer’s mother or father • An in-law (mother-in-law, father-in-law, sister-in-law, or brother-in-law) of the taxpayer, or • An unrelated person who lives in taxpayer’s home entire year

31. Qualifying Relative (2) • Support test • Taxpayer must pay > ½ of living expenses (support) • Scholarships of actual child excluded • Gross income test • Gross income < personal exemption amount ($4,050 in 2017)

32. Dependency Exemption Example • John is a 22-year-old student who has lived in the dorms for most of the year but spends the rest of the year living with his parents. He earned a $5,000 scholarship for the school year and has worked hard to support himself through school, earning $6,000 to pay for his own expenses. His parents have supported him by paying $7,000 for food, clothing, and lodging expenses. Are John’s parents able to claim him as a dependent?

33. Dependency Exemption Example Solution

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

35. Filing Status (2) • 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’s end • Joint and several liability for tax

36. Filing Status (3) • 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

37. Filing Status (4) • 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

38. Filing Status (5) • Single • Unmarried unless qualify for head of household

39. Filing Status (6) • Head of household • Unmarried or considered unmarried at end of year • See discussion of married individuals treated as unmarried (abandoned spouses) below • 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)

40. Filing Status (7) • Qualifying person • Qualifying child • Qualifying relative who is taxpayer’s mother or father • Parent need not 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

41. Filing Status (8) • Qualifying relative who is not the taxpayer’s parent • Person must have lived with taxpayer for more than half the year • Must qualify as taxpayer’s dependent • Must be related to taxpayer through qualified family relationship • If related only because lived with taxpayer for entire year, not a qualified person

42. Filing Status (9) • Head of household • Married individuals treated as unmarried (abandoned spouse) if individual • Is married at end of year (or is not legally separated from the other spouse) • Does not file a joint tax return with the other spouse • Pays > ½ the cost of maintaining a household that serves as principal abode for qualifying child for more than half the year • Lived apart from the other spouse for the last six months of the year (other than temporary absences)

43. Filing Status Example Assume that last year Rodney passed away, and during the current year Anita did not remarry but maintained a household for Braxton and Tara, her dependent children. Under these circumstances, what would Anita’s filing status be?

44. Filing Status Example Solution Answer: Qualifying widow

45. Filing Status Example (2) Assume Rodney and Anita divorced last year. During the current year, Braxton lives with Anita and Anita pays all the costs of maintaining the household for herself and Braxton. Under these circumstances, what is Anita’s filing status for the current year?

46. Filing Status Example Solution (2) Answer: Head of household

47. Filing Status Example (3) Assume Shawn (Rodney’s brother) lived with the Halls, but Shawn paid more than half the costs of maintaining a separate apartment that is the principal residence of his mother, Sharon, whose gross income is $1,500. Because Shawn provided more than half of Sharon’s support during the year, and because Sharon’s gross income was only $1,500, she qualifies as Shawn’s dependent (as a qualifying relative). In these circumstances, what is Shawn’s filing status?

48. Filing Status Example Solution (3) Answer: Head of household. Shawn paid more than half the costs of maintaining a separate household that is the principal place of abode for his mother, and his mother qualifies as his dependent.