1. Individual Income Tax Computation and Tax Credits
Chapter 8
Individual Income Tax Computation and Tax Credits

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

3. Federal Income Tax Computation (2)
Tax brackets or marginal tax rates on ordinary income
10%, 15%, 25%, 28%, 33%, 35%, and 39.6%
Marriage penalty or benefit
Who is likely to have penalty?
Both spouses receive income
Who is likely to have benefit?
One spouse receives income

4. Federal Income Tax Computation (3)
Exceptions to ordinary tax rates
Long-term capital gains (net capital gains)
Generally 0%,15%, or 20%, but can be as high as 28%
Two different tax rates on one gain is possible
Dividends
Qualified dividends generally taxed at 0%,15%, or 20%
Two different tax rates on one dividend is possible

5. Tax Computation Example
Assume that Courtney’s taxable income is $454,500 including $15,000 of qualifying dividends taxed at the preferential rate. What would be Courtney’s tax liability under these circumstances?

6. Tax Computation Example Solution

7. Net Investment IncomeTax
3.8% tax imposed on lesser of
Net investment income (e.g., interest, dividends, annuities, royalties, rents, passive activity income, net gains from disposing of property, less related allowed deductions) or
Excess of modified AGI over $250,000 (MFJ), $125,000 (MFS), and $200,000 (all others)

8. Federal Income Tax Computation (4)
Kiddie Tax
Net unearned income taxed at parents’ marginal rate
Net unearned income = unearned income in excess of $2,100
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, or
Child is over age 18 but under age 24, is a full-time student, and child’s earned income not greater than half of child’s support

9. Kiddie Tax Example
Suppose that during 2017, Deron received $1,100 in interest from an IBM bond, and he received another $2,200 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.)

10. 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 $2,100, he is potentially subject to the kiddie tax.

11. Kiddie Tax Example Solution (2)

12. Alternative Minimum Tax Formula

13. 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 proceeds not used to improve home)
Miscellaneous itemized deductions in excess of 2% floor

14. Alternative Minimum Tax (2)
Exemption phased out 25 cents for each dollar over threshold

15. Alternative Minimum Tax (3)
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

16. Alternative Minimum Tax (4)
Why is it so prevalent?
Individual tax rates have decreased since AMT enacted
AMT rates 26% or 28% vs. individual ordinary rates 10%, 15%, 25%, 28%, 33%, 35%, 39.6%

17. Employment FICA Taxes Employee Employer
Must pay FICA taxes on compensation from employer (6.2% Social Security tax rate; 1.45% to 2.35% Medicare tax rate)
$127,200 limit applies to Social Security portion
Multiple employers during year
Employer
Pays FICA tax on employee’s compensation (6.2% Social Security tax rate; 1.45% Medicare tax rate)
Withholds FICA tax from employee’s paycheck

18. Employment and Self-Employment Taxes
Self-employed taxpayers
Responsible for entire FICA tax (employee and employer share)
Tax base is net earnings from self-employment (Generally, net Schedule C income and multiply by .9235)
Same $127,200 limit applies to Social Security portion

19. Employment and Self-Employment Taxes (2)
If net earnings from self-employment < $400, no SE tax
How does $127,200 Social Security earnings limit apply when have both wages and SE earnings in the same year?
Wages use up limit first—favorable or unfavorable for taxpayer? Why?

20. Employment and Self-Employment Taxes Example
Assume that Courtney received $100,000 of taxable compensation from EWD in 2017, and she received $180,000 in self-employment income from her weekend consulting activities. What amount of self-employment taxes is Courtney required to pay on her $180,000 of business income? Assume that Courtney’s employer correctly withheld $6,200 of Social Security tax, $1,450 of Medicare tax, and $0 of .9 percent additional Medicare tax.

21. Employment and Self-Employment Taxes Example Solution

22. 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
Employer portion of self-employment taxes

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

24. 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)
Percentage of qualifying expenditures
Maximum qualifying expenditures: $3,000 one qualifying person, $6,000 two or more qualifying persons
Percentage depends on AGI (see Exhibit 8-9)

25. Nonrefundable Personal (2)

26. Nonrefundable Personal (3)
American opportunity credit (formerly Hope scholarship credit)
For first four years of postsecondary education
For eligible expenses and institutions only
Applied per student
Taxpayer, spouse, taxpayer’s dependents
Amounts paid by dependents treated as 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 subject to restrictions

27. American Opportunity 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 American opportunity credit (before phase-out) Courtney may claim for these expenses?

28. American Opportunity Credit Example Solution
Answer: $2,075. Because the cost of tuition and books are eligible expenses, Courtney may claim a maximum American opportunity credit before phase-out of $2,075 [($2,000 × 100%) + ($2,300 - $2,000) × 25%].

29. American Opportunity Credit Example (2)
Assuming Courtney qualifies for a $2,075 American opportunity credit, she is married filing jointly, and her AGI is $162,000, what amount of American opportunity credit would she be allowed to claim after phase-out?

30. American Opportunity Credit Example Solution (2)

31. Nonrefundable Personal (4)
Lifetime learning credit
Eligible expenses (tuition) for postsecondary 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

32. Nonrefundable Personal (5)
Education Credits
If deduct for AGI educational expenses for someone, no education credit allowed for that person
Could take American opportunity credit for one dependent and for AGI deduction for another

33. 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
See Exhibit 8-10

34. Refundable Personal (2)

35. Tax Credits Business Credits Promote certain behaviors
If credit exceeds tax, carry back one year and carry forward 20 years
Foreign Tax Credit
Hybrid business and personal—nonrefundable; carry back one year and carry forward 10 years

36. Tax Credits (2)

37. 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 15, June 15, September 15, and January 15 of the following year

38. Prepayments and Filing Requirements (2)
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

39. Prepayments and Filing Requirements (3)
Underpayment Penalties
Applied on quarterly basis
90%/4 = 22.5% of current-year liability must be paid in by deadline or
100%/4 = 25% of previous year’s liability must be paid in by deadline (110% for taxpayers with AGI > $150,000)
Penalty based on amount of underpayment at each quarter × federal short term rate + 3%

40. Prepayments and Filing Requirements (4)
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

41. Prepayments and Filing Requirements (5)
Due dates
April 15
Extend filing up to six months
May not extend due date for paying taxes

42. Prepayments and Filing Requirements (6)
Late Filing Penalty
5% of tax owed per month up to 25% if not fraudulent; 15% of tax owed per month up to 75% if fraudulent
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% if fraudulent
Combined late filing and late payment penalties may not exceed maximum amounts for either one

43. Late Filing and Late Payment Penalty Example
Assume Courtney filed her tax return on April 10 and included a check with the return for $4,059 made payable to the United States Treasury. The $4,059 consisted of her underpaid tax liability of $4,000 and her $59 underpayment penalty. If Courtney had waited until May 1 to file her return and pay her taxes, what late filing and late payment penalties would she owe?

44. Late Filing and Late Payment Penalty Example Solution
Answer: Her combined late filing penalty and late payment penalty would be $200 ($4,000 late payment × 5 percent × 1 month or portion thereof). Note that the combined late filing and late payment penalty is limited to 5 percent per month.