McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 04 Individual Income Tax Overview

4-2 Learning Objectives 1. Describe the formula for calculating an individual’s tax liability and generally explain each formula component. 2. Explain the requirements for determining a taxpayer’s personal and dependency exemptions. 3. Determine a taxpayer’s filing status.

4-3 Individual Income Tax Formula Realized income from whatever source derived Minus: Excluded or deferred income Equals: Gross income Minus: For AGI deductions Equals Adjusted gross income

4-4 Individual Income Tax Formula Adjusted Gross Income Minus: From AGI deductions: Greater of (a) Standard deduction or (b) Itemized deductions and Personal and dependency exemption Equals Taxable income

4-5 Individual Income Tax Formula Taxable income Times: Tax rates Equals: Income tax liability Add: Other taxes Equals: Total tax Minus: Credits Minus: Prepayments Equals: Taxes due or (refund)

4-6 Individual Income Tax Formula 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

4-7 Individual Income Tax Formula 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

4-8 Individual Income Tax Formula 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 Ordinary – ordinary rates from tax rate schedule Qualified dividends – 0 or 15% 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

4-9 Individual Income Tax Formula Capital assets Generally all assets except Accounts receivable Inventory Assets used in trade or business, including supplies

4-10 Individual Income Tax Formula Capital gains and losses Long-term capital gains generally taxed at 0% or 15% 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

4-11 Individual Income Tax Formula Deductions for AGI Deductions “above the line” Deducted in determining adjusted gross income Always reduce taxable income dollar for dollar

4-12 Individual Income Tax Formula 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?

4-13 Individual Income Tax Formula 2011 Standard deduction amounts $11,600 Married filing jointly $11,600 Qualifying widow or widower $5,800 Married filing separately $8,500 Head of household $5,800 Single Additional standard deduction amounts for age and eyesight (discuss in Chapter 6)

4-14 Individual Income Tax Formula 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.

4-15 Individual Income Tax Formula Other taxes include: Alternative minimum tax Self-employment taxes Tax credits Reduce tax liability dollar for dollar

4-16 Individual Income Tax Formula Tax prepayments Payments already made towards 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

4-17 Personal and Dependency Exemptions Personal exemptions For taxpayer and spouse if married filing jointly Dependency exemptions For those who qualify as the taxpayers’ dependents Exemption amount for 2011 is $3,700

4-18 Personal and Dependency Exemptions 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

4-19 Personal and Dependency Exemptions Qualifying child Relationship test Age test Residence test Support test

4-20 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.

4-21 Qualifying Child 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.

4-22 Qualifying Child 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

4-23 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 to Rodney and Anita?

4-24 Qualifying Child Example Solution TestBraxtonTara RelationshipYes, sonYes, daughter AgeYes, < 19 at year-end (and younger than his parents) Yes, < 24 at year-end and full-time student (and younger than his parents) ResidenceYes, lived at home entire year Yes, temporary absences such as school ok SupportYes, he provides < ½Yes, parents provide > ½ (scholarship does not count as self - support)

4-25 Qualifying Child Tie breaking rules Parents first Days living with each parent if parents living apart AGI– higher AGI gets exemption

4-26 Qualifying Child Example Braxton’s uncle Shawn (Rodney’s brother) lived in the Halls’s home (the same home Braxton lived in) for more than 11 months during Does Braxton meet the requirements to be considered Shawn’s qualifying child?

4-27 Qualifying Child Example Solution TestIs Braxton Shawn’s qualifying child? RelationshipYes, son of Shawn’s brother AgeYes, < 19 at year-end (and younger than Shawn) ResidenceYes, lived in the same residence as Shawn for more than half the year SupportYes, does not provide more than half of own support

4-28 Qualifying Child Example 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?

4-29 Qualifying Child Example Solution 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.

4-30 Personal and Dependency Exemptions Qualifying relative Relationship test Support test Gross income test

4-31 Qualifying Relative Relationship test a descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent), a sibling of the taxpayer or a stepmother, stepfather, stepbrother, stepsister, nephew, niece, aunt, uncle in-law (mother-in law, father-in-law, sister-in-law, and brother-in-law) of the taxpayer, or unrelated person who lives in taxpayer’s home entire year

4-32 Qualifying Relative Support test Taxpayer must pay > ½ of living expenses (support) Scholarships of actual child excluded Gross income test Gross income < personal exemption amount

4-33 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 for $7,000 for food, clothing, and lodging expenses. Are John’s parents able to claim him as a dependent?

4-34 Dependency Exemption Example Solution TestQualifying childQualifying relative RelationshipYes, child AgeYes, < 24 and full-time student Not applicable ResidenceYes, temporary absences ok Not applicable SupportYes, he provides < ½Yes, parents provide > ½ Gross incomeNot applicableNo, gross income > $3,700

4-35 Personal and Dependency Exemptions

4-36 Filing Status Five different filing statuses Married filing jointly Married filing separately Qualifying widow or widower (surviving spouse) Single Head of household

4-37 Filing Status 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 end Joint and several liability for tax

4-38 Filing Status 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

4-39 Filing Status 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

4-40 Filing Status Single Unmarried unless qualify for head of household

4-41 Filing Status Head of household Unmarried or considered unmarried at end of year See abandoned spouse discussion 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)

4-42 Filing Status Qualifying person Qualifying child Qualifying relative Parent (even if parent doesn’t 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

4-43 Filing Status Head of household Abandoned spouse treated as not married and is eligible for head of household if Spouse has not lived in home for last six months of year and Spouse who stays in home pays > ½ the cost of maintaining a household that serves as principal abode for qualifying child

4-44 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?

4-45 Filing Status Example Answer: Qualifying widow

4-46 Filing Status Example 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?

4-47 Filing Status Example Answer: Head of household

4-48 Filing Status Example 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?

4-49 Filing Status Example 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.