Chapter

1. Chapter 14 The Individual Tax Model

2. Filing Status - Married • If married on the last day of the year: status must be either Married filing joint or Married filing separately. • MFJ rates apply to Surviving Spouse • widow or widower with a dependent child for two more years after death of spouse. • MFS (married filing separately) rates are less favorable than single. • Generally only used for separated couples or US citizens or residents married to a nonresident alien

3. Filing Status - Unmarried • Single is the default category for unmarried individuals (neither surviving spouse nor head of household). • Head of household - maintain a home for either • child (need not be dependent) • dependent relative

4. Taxable Income Computation • Calculate total income totaling Line 22 on 1040. • Calculate Adjusted Gross Income (AGI) on Line 37 of 1040. • Subtract the greater of: • itemized deductions or • the standard deduction • Subtract total exemptions • Result is Taxable Income

5. Individual Tax Model – Gross Income / Exclusions • General Rule: Gross Income is “Broadly Conceived”: Includes all income subject to taxation unless specifically indicated as not taxable by law. • Exclusions include: • unrealized gains, gifts, inheritances, welfare type payments, many fringe benefits, returns of capital, Municipal Interest, some US Govt for higher education, life insurance proceeds. • Scholarships - excludible if • recipient is candidate for degree, amount received is not a payment for services, and is used to pay tuition, books, and other similar educational expenses • Foreign earned Income (Sec. 911) - build U.S. Economy • Exclude up to $95,100 of foreign earned income annually plus a housing allowance (exclusion cannot exceed earned income • Individual must be a bona fide resident of the foreign country for an entire tax year or be in the foreign country for 11 mos in any 12 month period.

6. Individual Tax Model: Special Income Inclusions • Annuities: Amount not taxed: Inv. / Expected Return * Pymts Rec • Deferred Compensation Plans: Defined Contribution Plans, Defined Benefit Plans - Qualified Retirement Plans • Prizes and Awards - include FMV • Social Security Benefits - up 85% may be taxed • Unemployment compensation is taxable • Alimony received is taxable / Child support is not includible but is not deductible either.

7. Special Rules • Dividends (cash and noncash) - FMV of prop received (subject to E& P provisions) • Stock dividends generally not taxable • Damages - personal (special rules) business damages not excludible. • Discharge of indebtedness - generally includible.

8. Business versus Investment • Business activity • Time and talent on regular basis • Profit partially attributable to personal involvement • Income is considered earned income • Hobby losses only deductible to extent of hobby income – not a business activity • Investment activity • Passive role as owner of income-producing property • Income is considered unearned income • Losses on personal use assets are not deductible – gains from sale are treated as capital assets.

9. Investments in Financial Assets • Securities include: • common and preferred stock • savings accounts, CDs, notes, bonds • Return on / Income from investment includes • Interest (ordinary income) • Dividends (special rules post May 2003) • Reinvested dividends are still taxable but increase basis. • gains (losses). • Mutual funds may report ‘distributed’ capital gains/losses. These are still taxable but increase basis even if no cash received.

10. Gains/Losses on Securities • Realization requires a sale or exchange • Gain/loss = Proceeds - adjusted basis • Character is capital - time period matters • Basis issues • reinvested dividends increase basis. • Sale of stock uses either specific ID or FIFO method of matching basis with sales. • Mutual fund shares sold typically use an average basis.

11. What to do with Capital Gains and Losses • SHORT TERM asset held for <= 1 year – gains taxed as ordinary income • LONG TERM asset held for > 1 year • L/T Gains taxed at lower capital gains tax rate of 15% • Net the gains and losses in each class (net ST, net LT, net 28%LT). • Special rule for sale of principal residence • Exclude gain on sale if home is principal residence 2 years out of 5 years ending on date of sale. • Exclude only one gain every 2 years. • Limits $500,000 MFJ, $250,000 other

12. Deductions for Adjusted Gross Income and AGI • Deductions for Adjusted Gross Income • Trade/Business Exp from a Sole Proprietorship are reported on Schedule C / or for a rental property are recorded on schedule E • Student Loan interest up to $2500 (Income limits apply) • Self Employed Expenses: 50% of SE tax, percentage of health insurance premiums, Keogh and Simple retirement plans • IRAs, Moving Expenses, Contributions to MSAs • Penalty for early withdrawal of savings • Result of Income less deductions for Adjusted Gross Income –is AGI (very key concept) - many deductions are a function of AGI (e.g., IRA deductions, medical expenses, charitable contributions) • Many items of gross income are also a function of AGI • Social Security Benefits, Passive Activity Losses

13. Deductions from AGI: Standard Deduction or Itemized Deductions • Standard Deduction Depends on filing status. For 2012/2013: • MFJ = $11,900/$12,200 • MFS = $5,950/ 6,100 • HOH = $8,700 / 8,950 • Single = $5,950 / 6,100 • Blind or aged (>=age 65) • MJF, MFS = additional $1,100/$1,200 • HOH or Single = additional $1,400/$1,500 • Take the higher of Standard Deduction or Itemized Deductions as a reduction of AGI in the computation of Taxable Income – Discussion of Itemized Deductions follows

14. Itemized Deductions / Personal Losses - Chapter 17 • Itemized deductions • a special class of deductions that allow taxpayers to derive tax benefits from certain personal & investment expenditures • Individuals deduct the greater of the standard deduction for his/her filing status or the total of his/her itemized deductions. • About 1/3 of all TPs claim itemized deductions • Itemized deductions are shown on Form 1040 Schedule A.

15. Medical Expense Deduction • Sec. 213 - qualified non-reimbursed medical expenses for a TP and dependents qualify for a deduction subject to a 7.5% of AGI floor. (only 5% of TPs benefit) • Qualifying expenses include • Medical insurance premiums / prescription drugs • Medical treatment / Physical & Psychological treatment • medical products, glasses, artificial limbs etc. • Capital improvements - limited to excess over increase in home value due to the improvements. • Capital improvements to remove structural barriers for physically handicapped - fully deductible. • Cosmetic surgery if it results from disease, personal injury or congenital defects. • No deduction allowed for: • Elective cosmetic surgery

16. Taxes • Sec 164 - lists deductible taxes • In general - only income taxes (other than Federal) and property taxes -ad valorem taxes on investment and personal property are deductible. • Taxes must be distinguished from assessments, fines & penalties which are not deductible. • Taxes are only deductible when they are the taxpayers obligations. No deduction for paying another persons taxes. No deduction is someone else pays your taxes. • 50% of SE tax is deductible, • Sales tax are deductible if total is greater than income taxes paid to a particular state.

17. Interest • Sec 163 - certain types of interest paid or accrued by a taxpayer during the year is deductible • Mortgage interest, some points, home equity interest or investment interest - are individual itemized deductions • Investment interest expense- deductible to extent of net investment income ( Gross Inv. Inc - Inv. Exp.) • Inv. Interest deduction not allowed if used to purchase tax exempt securities. • Qualified Residence Interest • indebtedness used to purchase, construct or improve the taxpayers residence • 2 homes allowed -Int on debt up to $1 Million is ded.. • Home equity interest limited to principal of 100K • Point on new loan or improvement loan deductible when paid. Refinancing - amortized over loan life.

18. Charitable Contributions • Sec 170 - gifts to qualified charities is deductible • Qualified charities: U.S. based organizations operated exclusively for religious, charitable, scientific, literary or educational purposes or for the prevention of cruelty to children or animals. • Contribution amount • reduced by value of any benefit received by the donor • LTCG property = value is FMV • No deduction allowed for contribution of services or rent free use of property. • Contribution Limits • LTCG property - limited to 30% of AGI • Total contributions limited to 50% of AGI • Excess contributions can be carried forward 5 years • If contributing property, TP must be able to substantiate value. • Must file form 8283 if noncash contributions > 500 • Independent appraisal is required when a single item of donated property is valued in excess of $5,000.

19. Casualty Losses / Miscellaneous Itemized Deductions • Casualty losses - unreimbursed losses due to theft or casualty. Losses are reduced by $100 and 10% of AGI. Excess, if any is deductible as an itemized deduction. • Misc. deductions subject to 2% of AGI limitation- (must exceed 2% of AGI to be deductible) • Unreimbursed Employee Business Expenses - union dues, uniforms, business use of auto, job search, other prof. Dues • Expenses for managing or safeguarding assets: safe deposit rental, investment advice, investment publications • Tax determination expenses: Tax prep fees, legal representation in tax audit, legal and accounting fees for tax planning, appraisals for tax reporting • Misc. deductions not subject to 2% limitation • gambling losses to extent of gambling winnings • unrecovered investments in annuities due to annuitants death.

20. Exemptions • Personal exemption for the taxpayer (2 for MFJ). • If you are a dependent on someone else’s return, can you still claim yourself? • Exemption = $3,800/$3,900 in 2012/2013 for each personal or dependency exemption.

21. Exemptions for Dependents • Family member OR live in your home for entire year. • You provide > 1/2 financial support • Dependent’s gross income < exemption amount ($3,650/$3,700 for 10/11) • waived for child < 19 OR student-child<24 • Dependent may not generally file a joint return. • Dependent must be a U.S. citizen OR a resident of US, Mex, Canada

22. Rich People • Phase-out of itemized deductions – Repealed in 2010 – likely to return post 2012 • Phase-out of exemptions – Repealed in 2010. Likely to return post 2012

23. Tax Credits • A credit is a dollar for dollar reduction in the tax liability. A deduction only reduces the tax by the marginal tax rate associated with that deduction. • Child Credit = $1,000 per child in 2007/8. Phases out for rich. • Dependent care credit (child < 13 years old). Credit amount between 30% and 20% of child care costs depending on income range. • Earned income credit. This is refundable - a transfer payment to working poor. Increases progressivity of tax rates. Credit is higher for taxpayers with children and phases out as income increases. • Excess FICA withholding is refunded through a tax return claim.

24. Tax Subsidies for Education • Hope scholarship credit / American job opportunity cred - 1st 4 years of college. Max $2500 per year per student based on tuition/fees. • Lifetime learning credit = 20% of tuition/fees: Max $5000 per year. • Hope and Lifetime phase out begins $80,000 MFJ • Education IRA - withdrawals spend on education are tax-free.

25. Payment and Filing Requirements • Taxes on wages are withheld each pay period. • Estimated taxes are due on April 15, June 15, September 15, and January 15. • Pay 90% of current year tax, 100% of prior year (or 110% of prior year AGI>$150,000). • Tax return due 4/15, but may be extended to 10/15 (LAST DATE).

26. Kiddie Tax • Children under age 18 with unearned income greater than $1,900 are subject to kiddie tax • The unearned income in excess of $1,900 is taxed at the parent’s highest marginal tax rate • The residual taxable income is taxed at the child’s rate. • What are the kiddie tax provisions designed to prevent?

27. Wealth Transfer Tax System – Covered on last day of class. • This is an excise tax system which is different from the income tax system. • Gift, estate, and generation skipping transfer taxes • The unified gift and estate tax is based on cumulative transfers over time (life + death). • Current tax rate is 35%

28. Gift Tax • Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation. • Exclude $13,000 per year per donee from taxable gifts. • No gift tax on gifts to spouse, charity, paying tuition or medical costs. • Can treat gift by one spouse as made 1/2 by other spouse.

29. Exclusion • Lifetime exclusion • $5,000,000

30. Income Tax Effects of Gifts • Gift is not taxable income to donee. • Donor’s adjusted basis in the property carries over to become the donor’s basis. • exception - use FMV if less than adjusted basis • After gift, any income derived from the property belongs to the donee.

31. Estate Tax • Taxed at unified estate and gift rate schedule • FMV of estate is taxed • Unlimited marital deduction • Reduce estate by taxes, charity, administrative expenses.

32. Income Tax Effect of Bequests • Receipt of a bequest is not taxable income to heir. • Basis = FMV at date of death = free income tax step-up in basis. (In 2010, wealthy estates generate carryover basis). • Trade-off - • gift now at low basis, perhaps avoid some transfer tax • keep and include in estate, but heirs get high basis