1. The Individual Tax Formula
Chapter 14
The Individual Tax Formula
McGraw-Hill/Irwin
© The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Objectives Filing status Computing taxable income
Standard deduction versus itemized deductions
Exemptions
Tax rates
Marriage penalty
Child credit and dependent care credit
Individual AMT
Payment and filing requirements

3. Filing Status Filing status
Reflects an individual’s marital and family situation
Affects the calculation of taxable income
Determines the rates at which income is taxed

4. Filing Status - Married
MFJ or MFS if married on the last day of the year
MFJ (married filing joint) rates
If spouse incomes are very similar, single rates generate lower overall tax
If spouse incomes are dissimilar, married rates generate lower overall tax
MFJ rates apply to Surviving Spouse status
A widow/widower with a dependent child for two years after death of spouse may file as Surviving Spouse
MFS (married filing separately) rates are less favorable than single

5. Filing Status - Unmarried
The Head of Household filing status may be used if the taxpayer maintains a home for either a:
Child (need not be dependent), or
Dependent relative
Single is the default filing status for unmarried individuals

6. Filing Status Examples
Application Problem 2
Mr. J and Mrs. J were legally divorced on November 18. Mr. J has not remarried and has no dependent children.
Mr. J and the first Mrs. J were legally divorced on April 2. Mr. J remarried the second Mrs. J on December 15. He has no dependent children.
Mrs. J died on July 23. Mr. J has not remarried and has no dependent children.
Mrs. J died on October 1, Mr. J has not remarried and maintains a home for one dependent child.

7. Application Problem 2 (continued)
Mrs. J died on May 30, Mr. J has not remarried and has no dependent children.
Mr. J and Mrs. J were legally divorced on May 30, Mr. J has not remarried and maintains a home for his two dependent children.

8. Taxable Income Computation
Step One: Calculate total income on Line 22 on Form 1040
Step Two: Calculate Adjusted Gross Income (AGI) on Line 34 of Form 1040
Step Three: Subtract the greater of itemized deductions or the standard deduction
Step Four: Subtract total exemptions

9. Step One Taxable income includes Business income
Salary or wage payments
Investment income

10. Step Two
Adjusted Gross Income (AGI) equals total income less specific above-the-line deductions
AGI is an extremely important number as many individual deductions and credits are limited by reference to a taxpayer’s AGI

11. Step Three Subtract the greater of The standard deduction
Or allowable itemized deductions

12. Standard Deduction Depends on filing status. For 2008
MFJ = $10,900
MFS = $5,450
HOH = $8,000
Single = $5,450
Blind or aged (>=age 65)
MJF, MFS = additional $1,050
HOH or Single = additional $1,350
Ben, age 65, and Mary, age 64, are married filing joint. What is their 2007 standard deduction?
$10,700 + $1,050 = $11,750

13. Itemized Deductions See Schedule A (Chapter 17 details)
Only 30% of individual filers elect to itemize their deductions
Bunching: if itemized deductions are about equal to standard deduction each year, the taxpayer should bunch deductions on alternate years and claim standard deduction on other years

14. Bunching Example
My dad gives $5,000 to charity each year. He is 77 and single. What is his standard deduction each year?
$5, , 300 = $6,650
Does he itemize?
No, as the standard deduction of $6,650 is greater than itemized deductions of $5,000
Suppose he gave $10,000 to the church every other year?
He would benefit by taking a $10,000 itemized deduction in the years of the charitable contribution and taking the standard deduction in the other years

15. Key Observation re: Individual Tax Deductions
A deduction listed as an above-the-line deduction always reduces taxable income
A deduction that must be itemized may have limited or even no effect on taxable income
The classification as either above-the-line or itemized deductions often reflects tax policy concerns and can change from year to year

16. Step Four Subtract exemption amounts
The taxpayer is allowed a personal exemption
Two exemptions are allowed if Married Filing Joint
If you are a dependent on someone else’s return, can you still claim an exemption for yourself? No!
The exemption amount is $3,500 for 2008 for each personal and dependency exemption

17. Exemptions for Dependents
If an individual passes all five tests, you may claim him or her as a dependent
Family member OR live in your home for entire year
You provide > 1/2 financial support
Dependent’s gross income < exemption amount of $3,500 in 2008
Waived for child < 19 years OR student-child<24 years
Dependent may not generally file a joint return
Dependent must be a U.S. citizen OR a resident of US, Mexico, or Canada

18. Application Problem 5
Mr. and Mrs. O file a joint income tax return. Determine if they can claim a personal exemption for any of the following individuals
Son Jack, age 20, who lives in his parents’ home and works full time as an auto mechanic. Jack is self-supporting except for the fact that he does not pay rent to his parents.
Daughter Brenda, age 22, who is a full-time college student. Brenda lives in a dormitory during the school year but her parents’ home is her permanent residence, and her parents provide 100 percent of her financial support.

19. Application Problem 5 (continued)
Nephew Eddie, age 16, who has lived in Mr. and Mrs. O’s home since Eddie is a high school student who earned $6,690 this summer working for a plumber. Since his aunt and uncle provide 100 percent of his financial support, Eddie is saving his earnings for college.
Mr. O’s mother Mildred, age 64, who lives in a retirement community. Mr. and Mrs. O provide about 65 percent of her financial support. Mildred earned $4,650 this year as a part-time librarian.
Mrs. O’s father Richard, age 76, who has lived in Mr. and Mrs. O’s home since Mr. and Mrs. O provide about 30 percent of his financial support. The rest of his support comes from Social Security.

20. High-income Taxpayers
Phase-out of itemized deductions - If AGI > $159,950 (MFJ) in 2008, itemized deductions are reduced by 2% of income > $159,950. Can’t reduce itemized deductions below 20% of total
Phase-out of exemptions - IF AGI > $239,950 (MFJ) in 2008, reduce exemption by 2/3% for each $2500 of AGI above the threshold
See appendices 14A and B for computations. Phase outs scheduled to be eliminated gradually starting 2006

21. The Four-step Procedure
Summarized as follows
Total Income
Less: Above-the-line deductions
Equals: Adjusted Gross Income (AGI)
Less: Standard Deduction or Itemized Deductions
Less: Personal Exemption amounts
Equals: Taxable Income

22. Tax Computations
Calculate the tax liability for each of the following using the tax rate schedule
Taxable income of $85,000, MFJ status
$ ($85,000 - $65,100) = $13,938
Taxable income of $120,000, Single status
$16, ($120,000 - $78,850) = $27,578

23. The Marriage Penalty Dilemma
The federal income tax system is not marriage neutral
Congress has provided some limited relief for lower income taxpayers
10 & 15% brackets are exactly twice that for single taxpayers
Standard deduction for married couples is exactly twice that for single taxpayers
A progressive tax system that allows married couples to file joint returns can be marriage neutral or horizontally equitable – but not both!

24. Credits
Child Credit = $1,000 per child under age 17 as of Dec. 31. Phases out for high-income taxpayers
Dependent care credit for children < 13 years old or a dependent who is physically or mentally incapable of caring for themselves. Credit amount is between 30% and 20% of child care costs depending on income range

25. Credits
Earned income credit is refundable - a transfer payment to working poor that increases progressivity of tax rates
Credit is higher for taxpayers with children and phases out as income increases
Maximum credit in 2008 is $4,824 for households with two or more children
Excess FICA withholding is refunded through a tax return claim

26. AMT (again!!) Why do we need AMT?
To guarantee that high-income taxpayers who dramatically reduced their regular tax by overindulging in tax preferences will still pay a fair share of income tax
More and more middle-income taxpayers with modest amounts of AMT adjustments or preferences are having to pay AMT

27. AMT (again!!)
Middle-income taxpayers are being subjected to AMT because regular income tax rates are adjusted for inflation annually while AMT rates are not
Unless Congress makes
major changes, the AMT
will affect 33 million
individuals by 2010

28. AMT
Taxable income +/– adj. (e.g. standard deduction or exemption amounts)
+ preferences = AMTI before exemption - exemption ($66,250 MFJ, phases out for rich) = AMTI x 26% (or 28% for higher AMTI levels) = TMT

29. Payment and Filing Requirements
Taxes on wages are withheld each pay period
Estimated taxes on self-employment income are due on April 15, June 15, September 15, and January 15

30. Payment and Filing Requirements
An underpayment penalty can be avoided by paying 90% of current year tax, 100% of prior year (or 110% of prior year if AGI>$150,000)
Tax return due 4/15; the filing of the return (not the payment of the taxes) may be extended to 8/15 then 10/15 (LAST DATE)