Chapter 4 Individual Tax Overview © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for

Chapter 4

Individual Tax Overview

© 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.

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


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


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


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


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 – 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

4-8


Capital assets Generally all assets except

Accounts receivable Inventory Assets used in trade or business, including supplies

4-9


Capital gains and losses Long-term capital gains 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


Deductions for AGI Deductions “above the line” Deducted in determining adjusted gross income Always reduce taxable income dollar for dollar

4-11


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


2013 Standard deduction amounts $12,200 Married filing jointly $12,200 Qualifying widow or widower $6,100 Married filing separately $8,950 Head of household $6,100 Single Additional standard deduction amounts for age

and eyesight (discuss in Chapter 6)

4-13


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


Other taxes include: Alternative minimum tax Self-employment taxes Medicare Contribution tax on net-investment

income Tax credits

Reduce tax liability dollar for dollar

4-15


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 2013 is $3,900

4-17


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


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


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


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)

Documents

Chapter 4 Individual Tax Overview © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for