Individual Income Tax Computation and Tax Credits

1. Chapter 7 Individual Income Tax Computation and Tax Credits

2. 2 Federal Income Tax Computation Regular tax computation dependent upon: Filing status Married filing jointly Qualifying widow or widower Married filing separately Head of household Single Progressive tax rates Tax rate schedules Tax tables

3. 3 Federal Income Tax Computation Tax brackets or marginal tax rates on ordinary income 10%, 15%, 25%, 28%, 33%, and 35%

4. 4 Federal Income Tax Computation Exceptions to ordinary tax rates Long-term capital gains (net capital gains) Generally 15% but can be as high as 28% or as low as 0% Two different tax rates on one gain is possible Dividends Qualifying dividends generally taxed at 15% but could be taxed as low as 0%. Two different tax rates on one dividend is possible

5. 5 Tax Computation Example Assume that Gram�s taxable income is $35,000 including $4,000 of qualifying dividends taxed at the preferential rate. What would be Gram�s tax liability on her income under these circumstances?

6. 6 Federal Income Tax Computation Unearned income shifting opportunities mitigated by: Reduced standard deduction for those claimed as dependent on another return Greater of $950 or ($300 + earned income). Kiddie tax

7. 7 Federal Income Tax Computation Kiddie tax Net unearned income taxed at parents� marginal rate Net unearned income = unearned income in excess of $1,900 Parents can elect to actually include this income on their tax return. Applies if Child is under age 18 at year end Child is 18 at year end but earned income not greater than half of child�s support Child is over age 18 but under age 24, full-time student, and earned income not greater than half of child�s support.

8. 8 Kiddie Tax Example Suppose that during 2009, Deron received $1,000 in interest from the IBM bond, and he received another $2,100 in interest income from a money market account that his parents have been contributing to over the years. What is Deron�s taxable income and corresponding tax liability? (Deron�s mother Courtney is subject to a 25% marginal tax rate.)

9. 9 Kiddie Tax Example Solution Because Deron is younger than 18 years of age at the end of the year and his net unearned income exceeds $1,900, he is potentially subject to the kiddie tax.

10. 10 Alternative Minimum Tax Formula Please place exhibit 6-1 where indicated in red.Please place exhibit 6-1 where indicated in red.

11. 11 Alternative Minimum Tax Items commonly added back to regular taxable income in computing AMT income Personal and dependency exemptions State income taxes Real property taxes Home-equity loan interest expense (if not proceeds not used to improve home) Miscellaneous itemized deductions in excess of 2% floor Please place exhibit 6-1 where indicated in red.Please place exhibit 6-1 where indicated in red.

12. 12 Alternative Minimum Tax Please place exhibit 6-1 where indicated in red.Please place exhibit 6-1 where indicated in red.

13. 13 Alternative Minimum Tax AMT is a tax based on an alternative more inclusive tax base than regular taxable income. Meant to ensure that taxpayers are paying some minimum level of tax. Who is most likely to pay it and why? High state taxes Multiple children Capital gains Please place exhibit 6-1 where indicated in red.Please place exhibit 6-1 where indicated in red.

14. 14 Alternative Minimum Tax Why is it becoming so prevalent? Exemption amount and phase-out threshold not indexed for inflation Individual tax rates have been decreasing. AMT rates 26% or 28% vs. individual ordinary rates 10%, 15%, 25%, 28%, 33%, 35% Please place exhibit 6-1 where indicated in red.Please place exhibit 6-1 where indicated in red.

15. 15 Employment and Self-Employment Taxes FICA taxes consist of two components: Social Security tax � 12.4% Wage base limited to $106,800 in 2009 Wage base limited to $102,000 in 2008 Medicare tax � 2.9% No wage base limitation

16. 16 Employment FICA Taxes Employee Must pay FICA taxes on compensation from employer Multiple employers during year Employer Pays � of employee�s FICA tax Withholds FICA tax from employee�s pay check

17. 17 Employment and Self-Employment Taxes Self-employed taxpayers Responsible for entire FICA tax Steps to computing SE tax Compute net Schedule C income (generally) and multiply by .9235 This equals net earnings from self-employment Determine Social Security tax 12.4% and Medicare tax 2.9% $106,800 limit applies to Social Security portion

18. 18 Employment and Self-Employment Taxes If net earnings from self-employment < $400, no SE tax. How does $106,800 Social Security earnings limit apply when have both wages and SE earnings in the same year? Wages use up limit first.

19. 19 Employment and Self-Employment Taxes Example Assume that Courtney received $100,000 of taxable compensation from EWD in 2009, and she received $18,000 in self-employment income from her weekend consulting activities. What amount of self-employment taxes is Courtney required to pay on her $18,000 of business income?

20. 20 Employment and Self-Employment Taxes Example Solution

21. 21 Employee vs. Independent Contractor Determining whether taxpayer is employee or independent contractor Primary question: who has control over how, when, where work is performed? Tax differences Amount of FICA or SE taxes payable Deductibility of expenses For AGI From AGI One-half of self-employment taxes

22. 22 Tax Credits Reduce tax liability dollar for dollar Consist of three categories Nonrefundable personal Refundable personal Business

23. 23 Nonrefundable Personal Child tax credit $1,000 for each qualifying child under age 17 at end of year Partially refundable in certain situations Phase-out amount not percentage Child and Dependent care credit Dependent under age of 13 (or disabled dependent) Maximum qualifying expenditures: $3,000 one qualifying person, $6,000 two or more qualifying persons. Depends on AGI

24. 24 Nonrefundable Personal

25. 25 Nonrefundable Personal Hope scholarship credit For first four years of post-secondary education For eligible expenses and institutions only Applied per student Taxpayer, spouse, taxpayer�s dependents Amounts paid by dependents; paid by taxpayer 100% of first $2,000 of eligible expenses and 25% of next $2,000 (maximum credit is $2,500) Phase-out based on AGI 40% of credit is refundable

26. 26 Hope Scholarship Credit Example Courtney paid $2,000 of tuition and $300 for books for Ellen to attend the University of Missouri�Kansas City during the summer at the end of her freshman year. What is the maximum Hope credit (before phase-out) Courtney may claim for these expenses?

27. 27 Hope Scholarship Credit Example Solution Answer: $2,075. Because the cost of tuition and books is an eligible expense Courtney may claim a maximum Hope credit before phase-out of $2,075 [($2,000 � 100%) + ($2,300 - $2,000) � 25%].

28. 28 Nonrefundable Personal Lifetime learning credit Eligible expenses (tuition) for post-secondary education Includes professional or graduate school Includes continuing education Applied per taxpayer MFJ return is one taxpayer 20% of up to $10,000 of eligible expenses Phase-out based on AGI

29. 29 Nonrefundable Personal Education credits If deduct for AGI educational expenses for someone, no education credit allowed for that person Could take Hope credit for one dependent and for AGI deduction for another

30. 30 Refundable Personal Making work pay credit Lesser of (1) 6.2% of earned income or (2) $400 ($800 if married filing jointly) Phased out based on AGI Taxpayers who are dependents of others are not eligible for credit

31. 31 Refundable Personal Earned income credit Negative income tax Must have earned income Must have at least one qualifying child or must be at least 25 years old and less than 65 and not a dependent of another

32. 32 Tax Credits Business credits Promote certain behaviors If credit exceeds tax, carry back one year and carryforward 20 years Foreign tax credit Hybrid business and personal � nonrefundable; carry back one year and carryforward 10 years

33. 33 Prepayments and Filing Requirements Taxes must be paid-as-you-go Withholdings Treated as made equally throughout the year Estimated tax payments Due on April 15th,, June 15th, September 15th, and January 15th of the following year

34. 34 Prepayments and Filing Requirements Underpayment penalties Safe-harbor requirements 90% of current tax liability or 100% of previous year�s tax liability (110% with higher AGI > $150,000) � 25% at each estimated filing deadline

35. 35 Prepayments and Filing Requirements Filing requirements Generally, must file if gross income > standard deduction + personal exemption amounts If married filing separately must file if gross income > personal exemption amount Lower thresholds for those claimed as dependent on another�s tax return

36. 36 Prepayments and Filing Requirements Late filing penalty 5% of tax owed per month up to 25% if not fraudulent; 15% of tax owed per month up to 75% No penalty if no tax is due Late payment penalty If don�t pay entire tax owed by due date of return .5% of amount due up to 25% maximum if not fraudulent 15% of amount due per month up to 75% Combined late filing and late payment penalties may not exceed maximum amounts for either one