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Chapter 3

Chapter 3. Computing The Tax. Tax Formula. FIGURE 3.1. Income -Broadly Conceived. Includes all the taxpayer’s income, both taxable and nontaxable Essentially equivalent to gross receipts It does not include a return of capital or receipt of borrowed funds. Accident insurance proceeds

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Chapter 3

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  1. Chapter 3 Computing The Tax

  2. Tax Formula FIGURE 3.1

  3. Income -Broadly Conceived • Includes all the taxpayer’s income, both taxable and nontaxable • Essentially equivalent to gross receipts • It does not include a return of capital or receipt of borrowed funds

  4. Accident insurance proceeds Annuities (cost element) Bequests Child support payments Cost-of-living allowance (for military) Damages for personal injury or sickness Gifts received Group term life insurance, premium paid by employer (for coverage up to $50,000) Inheritances Interest from state and local (i.e., municipal) bonds Life insurance paid on death Meals and lodging (if furnished for employer’s convenience) Military allowances Minister’s dwelling rental value allowance Railroad retirement benefits (to a limited extent) Scholarship grants (to a limited extent) Social Security benefits (to a limited extent) Unemployment compensation (to a limited extent) Veterans’ benefits Welfare payments Workers’ compensation benefits Partial List of Exclusions from Gross Income Exhibit 3-1

  5. Gross Income • The Internal Revenue Code defines gross income broadly as ‘‘except as otherwise provided . . . , all income from whatever source derived’’ • Gross income does not include unrealized gains

  6. Alimony Annuities (income element) Awards Back pay Bargain purchase from employer Bonuses Breach of contract damages Business income Clergy fees Commissions Compensation for services Death benefits Debts forgiven Director’s fees Dividends Embezzled funds Employee awards (in certain cases) Employee benefits (except certain fringe benefits) Estate and trust income Farm income Fees Gains from illegal activities Gains from sale of property Gambling winnings Group term life insurance, premium paid by employer (for coverage over $50,000) Partial List of Gross Income Items (slide 1 of 2) Exhibit 3.2

  7. Hobby income Interest Jury duty fees Living quarters, meals (unless furnished for employer’s convenience) Mileage allowance Military pay (unless combat pay) Notary fees Partnership income Pensions Prizes Professional fees Punitive damages Rents Rewards Royalties Salaries Severance pay Strike and lockout benefits Supplemental unemployment benefits Tips and gratuities Travel allowance (in certain cases) Treasure trove (found property) Wages Partial List of Gross Income Items (slide 2 of 2) Exhibit 3.2

  8. Deductions - Individual Taxpayers • Individual taxpayers have two categories of deductions: • Deductions for adjusted gross income (AGI) • Deductions from adjusted gross income

  9. Deductions For AGI (slide 1 of 2) • Sometimes known as above-the-line deductions • On the tax return, they are taken before the ‘‘line’’ designating AGI

  10. Deductions For AGI (slide 2 of 2) • Deductions for AGI include: • Ordinary and necessary expenses incurred in a trade or business • One-half of self-employment tax paid • Alimony paid • Certain payments to an IRA and Health Savings Accounts • Moving expenses • Fees for college tuition and related expenses • Interest on student loans • The capital loss deduction, and • Others

  11. Adjusted Gross Income (AGI) • AGI is an important subtotal • Serves as the basis for computing percentage limitations on certain itemized deductions such as • Medical expenses • Charitable contributions • Certain casualty losses • e.g., Medical expenses are deductible only to the extent they exceed 7.5% of AGI • This limitation might be described as a 7.5% “floor” under the medical expense deduction

  12. Deductions From AGI (slide 1 of 3) • Deductions from AGI include: • The greater of: • Itemized deductions, or • The standard deduction • Personal and dependency exemptions

  13. Deductions From AGI (slide 2 of 3) • A partial list of itemized deductions includes: • Medical expenses (in excess of 7.5% of AGI) • Certain taxes and interest • Charitable contributions • Casualty Losses (in excess of 10% of AGI) • Deductions for expenses related to • The production or collection of income, and • The management of property held for the production of income • Certain miscellaneous itemized deductions (in excess of 2% of AGI)

  14. Deductions From AGI (slide 3 of 3) • The standard deduction is the sum of two components: • Basic standard deduction • Amount allowed is based on taxpayer’s filing status • Additional standard deductions • Available for taxpayers who are • Age 65 or over, and/or • Blind • Two additional standard deductions are allowed for a taxpayer who is age 65 or over and blind • Amount allowed depends on filing status

  15. Standard Deduction (slide 1 of 2) • The basic standard deduction (BSD) amount depends on filing status of taxpayer Filing status 2009 2010 . Single $5,700 $5,700 MFJ, SS 11,400 11,400 HH 8,350 8,350 MFS 5,700 5,700 TABLE 3.1

  16. Standard Deduction (slide 2 of 2) • Additional standard deduction (ASD) • For taxpayers age 65 or older and/or legally blind Filing Status 2009 2010 . Single $1,400 $1,400 MFJ, SS 1,100 1,100 HH 1,400 1,400 MFS 1,100 1,100 TABLE 3.2

  17. Determining Standard Deduction • Examples (2010 tax year): • Taxpayer is single, blind, and age 65 or older • SD = $5,700 (BSD) + $1,400 (ASD) + $1,400 (ASD) = $8,500 • Taxpayers are married, filing jointly, one blind, and both age 65 or older • SD = $11,400 (BSD) + $1,100 (ASD) + $1,100 (ASD) + $1,100 (ASD) = $14,700

  18. ARRTA of 2009 - Two New Standard Deductions (slide 1 of 2) • ARRTA of 2009 provides two new, temporary, tax incentives to stimulate home ownership and the sale of autos • Provisions allow nonitemizers to deduct real property taxes and sales tax paid on purchase of autos as special standard deduction • Property taxes on a personal residence and sales taxes on a personal auto normally are deductions from AGI • Thus, the standard deductions alternative is a tax windfall for taxpayers who do not itemize

  19. ARRTA of 2009 - Two New Standard Deductions (slide 2 of 2) These new standard deductions are limited in duration (i.e., through 2009) Congressional action to extend the provisions is to be expected if the current economic downturn continues 19

  20. ARRTA of 2009 - Standard Deduction For Real Property Taxes • Currently, this temporary standard deduction for real property taxes is available for 2008 and 2009 tax returns • The amount allowed is the lesser of • The amount paid, or • $500 ($1,000 on a joint return)

  21. ARRTA of 2009 - Sales Tax Paid On The Purchase Of Autos • This temporary standard deduction is available for auto sales tax paid on purchases that occur from Feb. 17 through Dec. 31, 2009 • Deduction cannot exceed tax on first $49,500 of purchase price • Deduction is phased-out when taxpayer’s AGI exceeds $125,000 ($250,000 on a joint return) • Purchased vehicle (e.g., cars, SUVs, light trucks, motorcycles) cannot exceed gross weight of 8,500 lbs. • Original use must commence with the taxpayer

  22. Taxpayers Ineligible For Standard Deduction • Certain taxpayers cannot use the SD: • Married, filing separately, when either spouse itemizes deductions • Nonresident aliens • Individual filing return for tax year of less than 12 months because of change in annual accounting period

  23. SD Limit For Person Claimed as Dependent • Individual claimed as dependent has a BSD in 2010 limited to the greater of: • $950 or • $300 plus earned income (but not exceeding normal BSD) • ASD amount(s) still available

  24. Examples of SD Limit (slide 1 of 2) • Dependent’s SD (2010 tax year): • A blind child who earns $200 and is claimed by parents as a dependency exemption • SD = $950 (BSD) + $1,400 (ASD) = $2,350 • A child who earns $1,500 and is claimed by parents as a dependency exemption • SD = $1,800 [BSD equal to greater of $950 or ($300 + $1,500 earned income)]

  25. Examples of SD Limit (slide 2 of 2) • Examples of dependent’s SD (2010 tax year) • A child who earns $6,000 and is claimed by parents as a dependency exemption • SD = $5,700 [BSD limited to normal amount]

  26. Personal and DependencyExemption Amounts • Amounts • 2009: $3,650 per exemption • 2010: $3,650 per exemption • Personal and dependency exemptions • One per taxpayer (two personal exemptions when married, filing jointly) and for each dependent • Exception: Individual claimed as dependent by another taxpayer does not receive a personal exemption

  27. Personal and Dependency Exemptions In Year Of Death • Personal exemption allowed on joint return for spouse who dies during the year • Example: Tom and Betty were married in 1990. Tom dies on February 1, 2010. A personal exemption may be claimed for Tom on the taxpayers’ 2010 joint return.

  28. Dependency Exemptions (slide 1 of 2) • A dependency exemption is available for one who is either a qualifying child or a qualifying relative • A qualifying child must meet the following tests: • Relationship • Abode • Age, and • Support

  29. Dependency Exemptions (slide 2 of 2) • One objective of the Working Families Tax Relief Act of 2004 (WFTRA of 2004) • Establish a uniform definition of qualifying child for purposes of the: • Dependency exemption • Head-of-household filing status • Earned income tax credit • Child tax credit • Credit for child and dependent care expenses

  30. Relationship Test • The child must be the taxpayer’s: • Son or daughter • Stepson or stepdaughter • Brother or sister • Stepbrother or stepsister • Half brother or half sister, or • A descendant of such individual (e.g., grandchildren, nephews, nieces) • A child who has been adopted, or whose adoption is pending, qualifies • A foster child may also qualify

  31. Abode Test • A qualifying child must live with the taxpayer for more than half of the year • Temporary absences from the household due to special circumstances (e.g., illness, education) are not considered

  32. Age Test • The child must be under age 19 or under age 24 in the case of a student • A student is a child who, during any part of five months of the year, is enrolled full time at a school or government-sponsored on-farm training course • Individuals who are disabled are not subject to the age test

  33. Support • To be a qualifying child, the individual must not be self-supporting • Cannot provide more than one-half of his or her own support • In the case of a full-time student, scholarships are not considered to be support

  34. Tiebreaker Rules • In situations where a child may be a qualifying child for more than one person • Tiebreaker rules specify which person has priority in claiming the dependency exemption Table 3.4

  35. Qualifying Relative • In order to claim a dependency exemption for a qualifying relative, the following tests must be met: • Relationship • Gross income • Support

  36. Relationship Test • The relationship test for a qualifying relative is more expansive than for a qualifying child. Also included are the following relatives: • Lineal ascendants (e.g., parents, grandparents) • Collateral ascendants (e.g., uncles, aunts) • Certain in-laws (e.g., son-, daughter-, father-, mother-, brother-, and sister-in-law) • The relationship test also includes unrelated parties who live with the taxpayer

  37. Gross Income Test • Dependent’s gross income must be less than the exemption amount ($3,650 for 2010)

  38. Support Test • Taxpayer must provide more than 50% of the qualifying relative’s support • Only amounts expended are considered in the support test • Scholarships are not considered in the support test • Two exceptions to the support test: • Multiple support agreements • Children of divorced parents

  39. Multiple Support Agreements • Allows one member of a group providing > 50% of support to claim individual even though no one person provides > 50% support • Eligible parties must provide > 10% of support • Each eligible party must meet all other dependency requirements • Example - Allows children of elderly parent to claim exemption for parent when none individually meets the 50% support test

  40. Children of Divorced Parents • Special rules apply if the parents meet the following conditions: • They would have been entitled to the dependency exemption had they been married and filed a joint return • They have custody (either jointly or singly) of the child for more than half of the year • Under the general rule, the parent having custody of the child for the greater part of the year (i.e., the custodial parent) is entitled to the dependency exemption • General rule does not apply if • A multiple support agreement is in effect • Custodial parent issues a waiver in favor of the noncustodial parent

  41. Other Rules for Dependency Exemptions • In addition to fitting into either the qualifying child or the qualifying relative category, a dependent must also meet: • The joint return, and • The citizenship or residency tests

  42. Joint Return Test • Dependent cannot file a joint return with spouse unless: • Filing solely for refund of tax withheld • No tax liability exists for either spouse • Neither spouse required to file return

  43. Citizenship or Residency Test • Dependent must be a U.S. citizen or a resident of U.S., Canada, or Mexico for some part of the calendar year in which the taxpayer’s tax year begins • An exception provides that an adopted child need not be a citizen or resident of the U.S. (or a contiguous country) as long as his or her principal abode is with a U.S. citizen

  44. Child Tax Credit • $1,000 tax credit is allowed for each dependent child under the age of 17 • Qualifying child includes stepchildren and eligible foster children

  45. Filing Requirements (slide 1 of 2) • General Rule: Tax return must be filed if gross income is ≥ the sum of the standard deduction and exemption amount • ASD for blind does not apply for this determination • Special rules apply for dependents and self-employed taxpayers

  46. Filing Requirements (slide 2 of 2) • Tax return of an individual is due on or before the 15th day of the 4th month after taxpayer’s year end • Most individuals are calendar year taxpayers, thus, due date is April 15 • May obtain a 6 month extension of time to file • Excuses a taxpayer from penalty for failure to file, not from penalty for failure to pay • If more tax is owed, extension request (Form 4868) should be accompanied by check for balance of tax due

  47. Filing Status • There are 5 filing statuses • Single • Married, filing jointly • Surviving spouse (qualifying widow or widower) • Head of household • Married, filing separately • Filing status affects tax rate brackets, standard deduction, and other amounts

  48. Single Filing Status • Includes a taxpayer who is unmarried or separated from spouse by a divorce decree or separate maintenance agreement and does not qualify for another filing status • Marital status is determined as of the last day of the tax year • When a spouse dies during the year, marital status is determined as of the date of death

  49. Married Filing Jointly (MFJ) Filing Status • Married as of last day of taxable year, or • Spouse dies during taxable year

  50. Surviving Spouse Filing Status • Same tax rate brackets as married, filing jointly • File as surviving spouse for 2 years after death of spouse if taxpayer maintains a home in which a dependent child lives

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