Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. Chapter 4 Individual Income Tax Overview, Exemptions, and Filing Status

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 Gross income Minus: For AGI deductions Equals Adjusted gross income Minus: From AGI deductions: Greater of (a) Standard deduction or (b) Itemized deductions and Personal and dependency exemption Equals Taxable income

4-4 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)

4-5 Individual Income Tax Formula Individuals report taxable income to the IRS Reported on Form 1040 U.S. tax laws use all-inclusive gross 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

4-6 Individual Income Tax Formula Excluded and Deferred income not included in gross income 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

4-7 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 (current year tax rate is zero) Ordinary – ordinary rates from tax rate schedule Qualified dividends taxed at 0, 15%, or 20% depending on taxpayer’s income level 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 Net long-term gains taxed at preferential rates

4-8 Individual Income Tax Formula Capital assets Generally all assets except Accounts receivable Inventory Assets used in trade or business, including supplies

4-9 Individual Income Tax Formula Capital gains and losses Net long-term capital gains in excess of net short- term capital losses are generally taxed at 0%, 15%, or 20% depending on the taxpayer’s taxable income 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

4-10 Individual Income Tax Formula Deductions for AGI Deductions “above the line” Deducted in determining adjusted gross income Always reduce taxable income dollar for dollar

4-11 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?

4-12 Individual Income Tax Formula 2014 Standard deduction amounts $12,400 Married filing jointly $12,400 Qualifying widow or widower $6,200 Married filing separately $9,100 Head of household $6,200 Single Additional standard deduction amounts for age and eyesight (discuss in Chapter 6)

4-13 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.

4-14 Individual Income Tax Formula Other taxes include: Alternative minimum tax Self-employment taxes 3.8% Net investment income tax (also called the Medicare Contribution tax on net-investment income) Tax credits Reduce tax liability dollar for dollar

4-15 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

4-16 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 2014 is $3,950

4-17 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

4-18 Personal and Dependency Exemptions Qualifying child Relationship test Age test Residence test Support test

4-19 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.

4-20 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.

4-21 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

4-22 Qualifying Child Tie breaking rules Parents first Days living with each parent if parents living apart AGI– higher AGI gets exemption

4-23 Personal and Dependency Exemptions Qualifying relative Relationship test Support test Gross income test

4-24 Qualifying Relative Relationship test a descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent), a sibling of the taxpayer including a stepbrother or stepsister a son or daughter of the taxpayer’s brother or sister (not cousins) a sibling of the taxpayer’s mother or father 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

4-25 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

4-26 Personal and Dependency Exemptions

4-27 Filing Status Five different filing statuses Married filing jointly Married filing separately Qualifying widow or widower (surviving spouse) Single Head of household

4-28 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

4-29 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

4-30 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

4-31 Filing Status Single Unmarried unless qualify for head of household

4-32 Filing Status Head of household Unmarried or considered unmarried at end of year See discussion of married individuals treated as unmarried (abandoned spouses) below 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)

4-33 Filing Status Qualifying person Qualifying child Qualifying relative who is taxpayer’s mother or father Parent need not 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

4-34 Filing Status Qualifying relative who is not the taxpayer’s parent Person must have lived with taxpayer for more than half the year Must qualify as taxpayer’s dependent Must be related to taxpayer through qualified family relationship  If related only because lived with taxpayer for entire year, not a qualified person.

4-35 Filing Status Head of household Married individuals treated as unmarried (abandoned spouse) if individual Is married at end of year (or is not legally separated from the other spouse) Does not file a joint tax return with the other spouse Pays > ½ the cost of maintaining a household that serves as principal abode for qualifying child for more than half the year Lived apart from the other spouse for the last six months of the year (other than temporary absences)

4-36 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?

4-37 Filing Status Example Answer: Qualifying widow

4-38 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?

4-39 Filing Status Example Answer: Head of household

4-40 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?

4-41 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.