1. Chapter 8 Taxation of Individuals ©2007 South-Western Kevin Murphy Mark Higgins Kevin Murphy Mark Higgins

2. Transparency 8-2 2007 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.

3. Transparency 8-3 2007 South-Western Review of Tax Formula vThe formula for calculating taxable income generally is gross income minus allowable deductions. vFor individuals, deductions are split into two classes FDeductions for adjusted gross income FDeductions from adjusted gross income

4. Transparency 8-4 2007 South-Western Individual Tax Formula Gross Income minus: For Deductions Vnot restricted based on taxpayer’s income Vgenerally trade, business, rent or royalty expenses Adjusted Gross Income minus: From Deductions Vgenerally personal expenses Vamount is the greater of –Itemized deductions, or –standard deduction allowable

5. Transparency 8-5 2007 South-Western Individual Tax Formula Continued Individual Tax Formula Continued Adjusted Gross Income [AGI] minus: From Deductions minus: Personal & Dependency Exemptions $3,300 per person

6. Transparency 8-6 2007 South-Western Individual Tax Formula To Taxable Income Individual Tax Formula To Taxable Income Gross Income minus: For Deductions equals: Adjusted Gross Income [AGI] minus: From Deductions minus: Exemptions equals: Taxable Income

7. Transparency 8-7 2007 South-Western Individual Tax Formula The Tax Taxable Income times: Tax Rate equals: Income Tax Liability minus: Prepayments & Credits equals: Tax (or Refund) due

8. Transparency 8-8 2007 South-Western Personal and Dependency Exemptions vEach individual taxpayer is allowed one personal exemption vMay also claim one exemption for each dependent vOnly one exemption may be taken per person per year

9. Transparency 8-9 2007 South-Western Dependency Requirements vTwo types of dependents FQualifying child VMust pass five tests: age, non-support, relationship, principal residence, and citizenship FQualifying relative VMust also pass five tests: gross income, support, relationship, citizenship, and joint- return

10. Transparency 8-10 2007 South-Western Qualifying Child Tests ¶Age Test – Must be  younger than 19, or  a full-time student younger than 24, or  Permanently and totally disabled

11. Transparency 8-11 2007 South-Western 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

12. Transparency 8-12 2007 South-Western ¸Relationship Test – Child must be taxpayer’s: FChild FStepchild FFoster child FSibling FStepsibling FDecedent of any of the above Qualifying Child Tests

13. Transparency 8-13 2007 South-Western Qualifying Child Tests ¹Principal Residence Test FChild must live with taxpayer more than 50% of the year VAbsence due to illness, vacation, education, or military service does not count

14. Transparency 8-14 2007 South-Western Qualifying Child Tests vCitizen or Resident Test FChild must be a U.S. citizen, or FResident of the U.S., Canada, or Mexico

15. Transparency 8-15 2007 South-Western Qualifying Relative Tests ¶Gross Income Test  Gross income must be less than the exemption amount of $3,300

16. Transparency 8-16 2007 South-Western Qualifying Relative Tests ·Support Test FThe taxpayer must provide more than 50% of a dependent’s support for the year FTwo exceptions apply VCustodial parent may always claim a child VMultiple Support Agreement

17. Transparency 8-17 2007 South-Western Qualifying RelativeTests Multiple Support Agreement vWhen 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 FGroup must sign a support agreement FMay rotate the exemption among the group

18. Transparency 8-18 2007 South-Western Qualifying Relative Tests ¸Relationship Test FA dependent must be related to or reside with the taxpayer V 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) VNon-relatives must reside in the taxpayer’s home for the entire year

19. Transparency 8-19 2007 South-Western Dependency Tests ¹Citizenship or Residency Test FA dependent must be a U.S. citizen or a resident of a country adjacent to the U.S. ºJoint Return Test A dependent must not file a joint return FA joint return may be filed simply to claim a refund of all withheld tax

20. Transparency 8-20 2007 South-Western 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.

21. Transparency 8-21 2007 South-Western Filing Status Married, Filing Jointly vTaxpayers must be legally married on the last day of their tax year vA Surviving Spouse may continue to use Married, Filing Jointly status FFor two subsequent years FIf at least 1 dependent child lives at home FAnd the surviving spouse has not remarried

22. Transparency 8-22 2007 South-Western Filing Status Married, Filing Separately vTaxpayers married as of the last day of the year may choose to file separately

23. Transparency 8-23 2007 South-Western Filing Status Head of Household Unmarried taxpayers qualify if they FAre legally unmarried or an “abandoned spouse” at end of tax year, and FProvide over 50% of the cost of a home for VA qualifying dependent, or VA qualifying child, or VA parent âParent does not need to live with the taxpayer

24. Transparency 8-24 2007 South-Western 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

25. Transparency 8-25 2007 South-Western Deductions From AGI Individual taxpayer’s may deduct the larger of either a standard deduction or total itemized deductions.

26. Transparency 8-26 2007 South-Western 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

27. Transparency 8-27 2007 South-Western Itemized Deductions Through legislative grace, there are 6 categories of personal expenses individual taxpayers may deduct. Medical Taxes Interest Charitable Contributions Casualty Losses Miscellaneous

28. Transparency 8-28 2007 South-Western Medical Expenses vUnreimbursed medical expenses of the taxpayer(s) and medical dependents are deductible FMedical dependents may violate the gross income and the joint return tests FCosts include premiums for health and accident insurance and transportation at 18 cents per mile (for 2006) FDeduction is limited to the excess of total costs over 7.5% of AGI

29. Transparency 8-29 2007 South-Western Taxes vAmounts paid for either sales taxes or state and local income taxes are deductible vAmounts paid for real estate and other personal property taxes are deductible FNo payments for federal taxes are allowed FProperty taxes must be based on value

30. Transparency 8-30 2007 South-Western Interest vQualified home mortgage interest is deductible FDebt must be secured by a principal residence FQualified interest is interest paid for VAcquisition debt up to $1 million VHome equity debt up to $100,000

31. Transparency 8-31 2007 South-Western Interest vPoints on a qualified mortgage are deductible if paid to acquire financing FMust be stated as a % of the loan value FDeductible currently if paid on acquisition debt VIf for refinancing, amortize over the life of the loan

32. Transparency 8-32 2007 South-Western Interest vThe 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

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

34. Transparency 8-34 2007 South-Western Charitable Contributions vDeduction amount for property depends of the type of property given FOrdinary income property or short-term capital gain property VDeduction is the lesser of the property’s âFMV, or âadjusted basis FDeduction amount for long-term capital gain property is FMV

35. Transparency 8-35 2007 South-Western Charitable Contributions Limitations vThe overall deduction cannot exceed 50% of AGI vDeduction for long-term capital gain property cannot exceed 30% of AGI FIf the taxpayer elects to deduct the adjusted basis rather than FMV, the 50% limit is used vContributions to non-operating private foundations are subject to additional limits

36. Transparency 8-36 2007 South-Western Casualty Losses vThese were discussed in Chapter 7. vLoss is the lesser of FThe property’s adjusted basis, or FThe decline in the value of the property (repair cost) vLoss is reduced by FInsurance proceeds received, F$100 per event (Administrative convenience), and F10% of AGI per year

37. Transparency 8-37 2007 South-Western Miscellaneous Deductions Other various expenses are combined as miscellaneous itemized deductions and are either fully deductible or partially deductible

38. Transparency 8-38 2007 South-Western Miscellaneous Fully Deductible Fully Deductible expenses include: vGambling losses to the extent of gambling winnings, vImpairment-related-work expenses of disabled taxpayers, and vUnrecovered capital from a terminated annuity

39. Transparency 8-39 2007 South-Western Miscellaneous Partially Deductible vOther miscellaneous expenses are partially deductible to the extent their total exceeds 2% of AGI FUnreimbursed employee expenses FInvestment expenses other than interest FHobby-related expenses

40. Transparency 8-40 2007 South-Western Reductions for High-Income Taxpayers Taxpayers whose AGI exceeds set threshold amounts must reduce their total itemized deductions and their total personal & dependency exemptions.

41. Transparency 8-41 2007 South-Western Itemized Deduction Phase-Out vDeductions for medical expenses, investment interest, casualty and theft losses and gambling losses are not subject to reduction vCalculated phase-out amount for taxpayers with AGI over $150,500 is the smaller of F3% of (AGI - $150,500), or F80% of the amount subject to reduction vCalculated amount reduced by one-third (for 2006 & 2007)

42. Transparency 8-42 2007 South-Western Exemption Phase-Out Initial calculation for taxpayers with AGI over a threshold amount is AGI - Threshold 2% X $2,500

43. Transparency 8-43 2007 South-Western Exemption Phase-Out As with the phase-out of itemized deductions, the initial calculated amount for the exemption phase-out is reduced by one-third for 2006 and 2007

44. Transparency 8-44 2007 South-Western Exemption Phase-Out Threshold Amounts

45. Transparency 8-45 2007 South-Western Restrictions on Dependents vA person claimed as a dependent by another taxpayer FMay not also claim a personal exemption FMay report a standard deduction of V$850, or VThe amount of earned income plus $300, but not more than the regular standard deduction amount

46. Transparency 8-46 2007 South-Western Restrictions on Dependents vThe 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

47. Transparency 8-47 2007 South-Western Tax Credits A tax credit is a direct reduction of tax liability. The purposes of tax credits are Fto provide incentives for taxpayers to engage in specific activities Fto provide equity among taxpayers Fto provide tax relief for low-income taxpayers

48. Transparency 8-48 2007 South-Western Child Tax Credit vNon-refundable $1,000 credit for each qualifying child who is under age 17 vPhased-out at rate of $50 for each $1,000 of AGI greater than F$110,000 if MFJ, $55,000 if MFS, $75,000 for others

49. Transparency 8-49 2007 South-Western Child Credit May Be Refundable vWith one or two children FRefund amount = 15%(Earned Income - $11,300) vWith three or more children FAmount = 15%(Earned Income - $11,300), but FLimited to tax liability + Social Security tax paid - Earned Income Credit

50. Transparency 8-50 2007 South-Western Earned Income Credit vThe earned income credit provides tax relief to low-income taxpayers vCredit is refundable FThe taxpayer may receive a refund if the credit exceeds the tax liability

51. Transparency 8-51 2007 South-Western Earned Income Credit Eligibility Requirements vTaxpayer or spouse FMust live more than half the year in the U.S. FMust be older than 25 and younger than 65 FCannot be a dependent of another FMay not have portfolio or passive income in excess of $2,800 vMarried taxpayers must file jointly

52. Transparency 8-52 2007 South-Western Earned Income Credit Amount vAmount of the credit depends on FThe taxpayer’s earned income VPhased-out after maximum limit is reached FThe number of qualifying children living in the taxpayer’s home VChild must be less than 19 years old (24 if full-time student) VMust be a natural, step, or foster child and reside with taxpayer more than half of the year vAmount is determined using an IRS table

53. Transparency 8-53 2007 South-Western Child and Dependent Care Credit vThe child and dependent care credit provides tax relief to taxpayers so that they can be employed vTwo qualifying conditions must be met FExpenses must be incurred so that taxpayer can be employed FExpenses must be for the care of qualified individuals

54. Transparency 8-54 2007 South-Western Child and Dependent Care Credit Qualifications vQualified individuals are FDependents younger than 13 years old, or FA dependent or spouse who is physically or mentally incapacitated vThe credit amount may not exceed $3,000 ($6,000 if more than one qualified individual)

55. Transparency 8-55 2007 South-Western Child and Dependent Care Credit Reductions vCredit amount is 35% of qualified expense FPercentage is reduced as AGI exceeds $15,000, but never below 20% AGI - $15,000 35% - (1% X ) $2,000

56. Transparency 8-56 2007 South-Western Higher Education Credits vTwo credits FHOPE Scholarship Credit FLifetime Learning Credit vMay claim only one per qualifying student FMust be enrolled at least one semester FMust be enrolled at least half-time vMay not claim if deduction taken for Higher Education Expenses

57. Transparency 8-57 2007 South-Western Higher Education Credit Qualifying Expenses vExpenses must be for higher education of taxpayer, spouse, or dependent vTuition and related fees are reduced by the amount of any scholarship or fellowship received

58. Transparency 8-58 2007 South-Western HOPE Scholarship Credit vMaximum non-refundable $1,650 credit F100% of the first $1,100, plus 50% of the second $1,100 vMay be claimed by student or qualifying taxpayer vSeparate credit for each student

59. Transparency 8-59 2007 South-Western HOPE Scholarship Credit Limitations vAvailable only for first two years of post- secondary education vPhased-out for AGI greater than F$90,000 if MFJ F$45,000 if other Possible credit X [1 - {(AGI - phase-out) / 20,000}]

60. Lifetime Learning Credit vMaximum non-refundable $2,000 credit F20% of the first $10,000 of qualifying expenses vOnly one credit per return (regardless of number of students in household) vExpense can be for any course work to acquire or improve job skills vPhased-out same as HOPE Credit Transparency 8-60 © 2004 South-Western College Publishing

61. Transparency 8-61 2007 South-Western Filing Requirements vIndividuals must file a return when gross income > (standard deduction + additional deductions for age + personal exemption) v3 exceptions: FSelf-employment income exceeds $400 FMFS whose gross income exceeds $3,300 FCan be claimed as a dependent on another’s return and unearned income exceeds $850

62. End of Chapter 8