Taxation of Individuals Chapter 8 Taxation of Individuals Kevin Murphy Mark Higgins ©2008 South-Western

Taxation of Individuals Individuals are the biggest single group of taxpaying entities. As taxpaying entities, they must adopt an annual accounting period and method of accounting.

Review of Tax Formula The formula for calculating taxable income generally is gross income minus allowable deductions. For individuals, deductions are split into two classes Deductions for adjusted gross income Deductions from adjusted gross income

Individual Tax Formula Gross Income minus: For Deductions not restricted based on taxpayer’s income generally trade, business, rent or royalty expenses Adjusted Gross Income minus: From Deductions generally personal expenses amount is the greater of Itemized deductions, or standard deduction allowable

Individual Tax Formula Continued Adjusted Gross Income [AGI] minus: From Deductions minus: Personal & Dependency Exemptions $3,400 per person

Individual Tax Formula To Taxable Income Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI] minus: From Deductions minus: Exemptions equals: Taxable Income

Individual Tax Formula The Tax Taxable Income times: Tax Rate equals: Income Tax Liability minus: Prepayments & Credits equals: Tax (or Refund) due

Personal and Dependency Exemptions Each individual taxpayer is allowed one personal exemption May also claim one exemption for each dependent Only one exemption may be taken per person per year

Dependency Requirements Two types of dependents Qualifying child Must pass five tests: age, non-support, relationship, principal residence, and citizenship Qualifying relative Must also pass five tests: gross income, support, relationship, citizenship, and joint-return

Qualifying Child Tests Age Test – Must be younger than 19, or a full-time student younger than 24, or Permanently and totally disabled

Qualifying Child Tests Non-Support Test – Child may not Supply more than 50% of their own support Scholarships don’t count Note: the taxpayer who claims the child does not have to provided more than 50% of the support

Qualifying Child Tests Relationship Test – Child must be taxpayer’s: Child Stepchild Foster child Sibling Stepsibling Decedent of any of the above

Qualifying Child Tests Principal Residence Test Child must live with taxpayer more than 50% of the year Absence due to illness, vacation, education, or military service does not count

Qualifying Child Tests Citizen or Resident Test Child must be a U.S. citizen, or Resident of the U.S., Canada, or Mexico

Qualifying Relative Tests Gross Income Test Gross income must be less than the exemption amount of $3,400

Qualifying Relative Tests Support Test The taxpayer must provide more than 50% of a dependent’s support for the year Two exceptions apply Custodial parent may always claim a child Multiple Support Agreement

Qualifying RelativeTests Multiple Support Agreement When two or more people together provide over half of another’s support, any one who contributes over 10% of the support may claim the exemption Group must sign a support agreement May rotate the exemption among the group

Qualifying Relative Tests Relationship Test A dependent must be related to or reside with the taxpayer Relatives are ancestors, descendants, and other blood or in-law relations such as siblings, aunts, uncles, nieces and nephews (cousins don’t count, but adopted children do) Non-relatives must reside in the taxpayer’s home for the entire year

Dependency Tests Citizenship or Residency Test A dependent must be a U.S. citizen or a resident of a country adjacent to the U.S. Joint Return Test A dependent must not file a joint return A joint return may be filed simply to claim a refund of all withheld tax

Filing Status Tax law recognizes the difference in ability-to-pay by basing exemptions, standard deductions and tax rates on an individual’s filing status.

Filing Status Married, Filing Jointly Taxpayers must be legally married on the last day of their tax year A Surviving Spouse may continue to use Married, Filing Jointly status For two subsequent years If at least 1 dependent child lives at home And the surviving spouse has not remarried

Filing Status Married, Filing Separately Taxpayers married as of the last day of the year may choose to file separately

Filing Status Head of Household Unmarried taxpayers qualify if they Are legally unmarried or an “abandoned spouse” at end of tax year, and Provide over 50% of the cost of a home for A qualifying dependent, or A qualifying child, or A parent Parent does not need to live with the taxpayer

Filing Status Single Taxpayers who are not legally married on the last day of the year and do not qualify as Head of Household must file Single

Deductions From AGI Individual taxpayer’s may deduct the larger of either a standard deduction or total itemized deductions.

Standard Deductions The standard deduction is based on filing status Taxpayers who are over 64 years of age receive extra amounts, as do blind taxpayers

Itemized Deductions Through legislative grace, there are 6 categories of personal expenses individual taxpayers may deduct. Charitable Contributions Medical Taxes Casualty Losses Interest Miscellaneous

Medical Expenses Unreimbursed medical expenses of the taxpayer(s) and medical dependents are deductible Medical dependents may violate the gross income and the joint return tests Costs include premiums for health and accident insurance and transportation at 18 cents per mile Deduction is limited to the excess of total costs over 7.5% of AGI

Taxes Amounts paid for either sales taxes or state and local income taxes are deductible Amounts paid for real estate and other personal property taxes are deductible No payments for federal taxes are allowed Property taxes must be based on value

Interest Qualified home mortgage interest is deductible Debt must be secured by a principal residence Qualified interest is interest paid for Acquisition debt up to $1 million Home equity debt up to $100,000

Interest Points on a qualified mortgage are deductible if paid to acquire financing Must be stated as a % of the loan value Deductible currently if paid on acquisition debt If for refinancing, amortize over the life of the loan

Interest The deduction for investment interest is limited to the amount of net investment income Investment Income less: Investment Expenses Net Investment Income investment income = portfolio income plus gross income and gains from investment assets investment expenses do not include interest

Charitable Contributions Contributions made to qualifying charitable organizations are deductible Organizations established for religious, educational, charitable, scientific or literary purposes qualify Deductible amount includes cash paid and the value of property given and $0.14 per mile driven Three major limitations exist Contributions in excess of limitations may be carried forward for five years © 2004 South-Western College Publishing Transparency 8-33

Charitable Contributions Deduction amount for property depends of the type of property given Ordinary income property or short-term capital gain property Deduction is the lesser of the property’s FMV, or adjusted basis Deduction amount for long-term capital gain property is FMV

Charitable Contributions Limitations The overall deduction cannot exceed 50% of AGI Deduction for long-term capital gain property cannot exceed 30% of AGI If the taxpayer elects to deduct the adjusted basis rather than FMV, the 50% limit is used Contributions to non-operating private foundations are subject to additional limits

Casualty Losses These were discussed in Chapter 7. Loss is the lesser of The property’s adjusted basis, or The decline in the value of the property (repair cost) Loss is reduced by Insurance proceeds received, $100 per event (Administrative convenience), and 10% of AGI per year

Miscellaneous Deductions Other various expenses are combined as miscellaneous itemized deductions and are either fully deductible or partially deductible

Miscellaneous Fully Deductible Fully Deductible expenses include: Gambling losses to the extent of gambling winnings, Impairment-related-work expenses of disabled taxpayers, and Unrecovered capital from a terminated annuity

Miscellaneous Partially Deductible Other miscellaneous expenses are partially deductible to the extent their total exceeds 2% of AGI Unreimbursed employee expenses Investment expenses other than interest Hobby-related expenses

Reductions for High-Income Taxpayers Taxpayers whose AGI exceeds set threshold amounts must reduce their total itemized deductions and their total personal & dependency exemptions.

Itemized Deduction Phase-Out Deductions for medical expenses, investment interest, casualty and theft losses and gambling losses are not subject to reduction Calculated phase-out amount for taxpayers with AGI over $156,400 is the smaller of 3% of (AGI - $156,400), or 80% of the amount subject to reduction

Exemption Phase-Out Initial calculation for taxpayers with AGI over a threshold amount is AGI - Threshold 2% X $2,500

Exemption Phase-Out Threshold Amounts

Restrictions on Dependents A person claimed as a dependent by another taxpayer May not also claim a personal exemption May report a standard deduction of $850, or The amount of earned income plus $300, but not more than the regular standard deduction amount

Restrictions on Dependents The net unearned income of a child under the age of 14 is taxed at the parent’s marginal tax rate Unearned Income less: $1,700 Net Unearned Income

Tax Credits A tax credit is a direct reduction of tax liability. The purposes of tax credits are to provide incentives for taxpayers to engage in specific activities to provide equity among taxpayers to provide tax relief for low-income taxpayers

Child Tax Credit Non-refundable $1,000 credit for each qualifying child who is under age 17 Phased-out at rate of $50 for each $1,000 of AGI greater than $110,000 if MFJ, $55,000 if MFS, $75,000 for others

Child Credit May Be Refundable With one or two children Refund amount = 15%(Earned Income - $11,750) With three or more children Amount = 15%(Earned Income - $11,750), but Limited to tax liability + Social Security tax paid - Earned Income Credit

Earned Income Credit The earned income credit provides tax relief to low-income taxpayers Credit is refundable The taxpayer may receive a refund if the credit exceeds the tax liability

Earned Income Credit Eligibility Requirements Taxpayer or spouse Must live more than half the year in the U.S. Must be older than 25 and younger than 65 Cannot be a dependent of another May not have portfolio or passive income in excess of $2,800 Married taxpayers must file jointly

Earned Income Credit Amount Amount of the credit depends on The taxpayer’s earned income Phased-out after maximum limit is reached The number of qualifying children living in the taxpayer’s home Child must be less than 19 years old (24 if full-time student) Must be a natural, step, or foster child and reside with taxpayer more than half of the year Amount is determined using an IRS table

Child and Dependent Care Credit The child and dependent care credit provides tax relief to taxpayers so that they can be employed Two qualifying conditions must be met Expenses must be incurred so that taxpayer can be employed Expenses must be for the care of qualified individuals

Child and Dependent Care Credit Qualifications Qualified individuals are Dependents younger than 13 years old, or A dependent or spouse who is physically or mentally incapacitated The credit amount may not exceed $3,000 ($6,000 if more than one qualified individual)

Child and Dependent Care Credit Reductions Credit amount is 35% of qualified expense Percentage is reduced as AGI exceeds $15,000, but never below 20% AGI - $15,000 35% - (1% X ) $2,000

Higher Education Credits Two credits HOPE Scholarship Credit Lifetime Learning Credit May claim only one per qualifying student Must be enrolled at least one semester Must be enrolled at least half-time May not claim if deduction taken for Higher Education Expenses

Higher Education Credit Qualifying Expenses Expenses must be for higher education of taxpayer, spouse, or dependent Tuition and related fees are reduced by the amount of any scholarship or fellowship received

HOPE Scholarship Credit Maximum non-refundable $1,650 credit 100% of the first $1,100, plus 50% of the second $1,100 May be claimed by student or qualifying taxpayer Separate credit for each student

HOPE Scholarship Credit Limitations Available only for first two years of post-secondary education Phased-out for AGI greater than $94,000 if MFJ $47,000 if other Possible credit X [1 - {(AGI - phase-out) / 20,000}]

Lifetime Learning Credit Maximum non-refundable $2,000 credit 20% of the first $10,000 of qualifying expenses Only one credit per return (regardless of number of students in household) Expense can be for any course work to acquire or improve job skills Phased-out same as HOPE Credit Transparency 8-59

Filing Requirements Individuals must file a return when gross income > (standard deduction + additional deductions for age + personal exemption) 3 exceptions: Self-employment income exceeds $400 MFS whose gross income exceeds $3,400 Can be claimed as a dependent on another’s return and unearned income exceeds $850