Income Tax Fundamental 2011

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Income Tax Fundamentals, 2011 EditionGerald E. Whittenburg and Martha Altus-Buller

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G e t t y I m a g e s , I n c .





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Chapter 1

The IndividualIncome Tax Return

LEARNING OBJECTIVES.......................................................................After completing this chapter, you should be able to:

LO 1.1 Understand the history and objectives of U.S. tax law.LO 1.2 Describe the different entities subject to tax and reporting

requirements.LO 1.3 Understand and apply the tax formula for individuals.LO 1.4 Identify individuals who must file tax returns and select

their correct filing status.LO 1.5 Calculate the number of exemptions and the exemption

amounts for taxpayers.LO 1.6 Calculate the correct standard or itemized deduction

amounts for taxpayers.LO 1.7 Compute basic capital gains and losses.LO 1.8 Access and use various Internet tax resources.

Overview This chapter introduces the United States individual income tax system. Important ele-ments of the individual tax formula are covered. These include the tax calculation, whomust file, filing status, exemptions, and the interaction of itemized deductions and the stan-dard deduction. The chapter illustrates all the steps required for completion of Form1040EZ, Income Tax Return for Single and Joint Filers With No Dependents, andForm 1040A, Short Form U.S. Individual Income Tax return. Also included is a discussionof reporting and taxable entities.

An introduction to capital gains and losses is included to provide a basic understandingof capital transactions prior to the detailed coverage in Chapter 8. An overview of tax infor-

mation available at the IRS Web site and other helpful tax Web sites is also included. A discussion of the process for electronic filing (e-filing) of an individual tax return completesthe chapter.

1-1





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SECTION 1.1 HISTORY AND OBJECTIVES OF THE TAX SYSTEM The United States income tax was author ized by the Sixteenth Amendment to theConstitution on March 1, 1913. Prior to the adoption of this amendment, theUnited States government had levied various income taxes for limited periods of time. For example, an income tax was used to help finance the Civil War. The find-

ing by the courts that the income tax law enacted in 1894 was unconstitutional even-tually led to the adoption of the Sixteenth Amendment. Since adoption of theamendment, the constitutionality of the income tax has not been questioned by thefederal courts.

Many people believe the sole purpose of the income tax is to raise revenue to oper-ate the government. This belief is not accurate. The tax law has many goals other thanraising revenue. These goals fall into two general categories—economic goals andsocial goals—and it is often unclear which goal a specific tax provision was writtento meet. Tax provisions have been used for such economic motives as reduction of unemployment, expansion of investment in productive (capital) assets, and controlof inflation. Specific examples of economic tax provisions are the limited allowancefor expensing of capital expenditures and the accelerated cost recovery system

(ACRS or MACRS) of depreciation. In addition to pure economic goals, the tax lawis used to encourage certain business activities and industries. For example, an incometax credit encourages businesses to engage in research and development activities, thenew energy credits encourage investment in solar and wind energy businesses, and aspecial deduction for soil and water conservation expenditures related to farm landbenefits farmers.

Social goals have also resulted in the adoption of many specific tax provisions. The childand dependent care credit, the earned income credit, and the charitable contributiondeduction are examples of tax provisions designed to meet social goals. Social provisionsmay influence economic activities, but they are written primarily to encourage taxpayersto undertake activities to benefit themselves and society.

An example of a provision that has both economic and social objectives is the provisionallowing the gain on the sale of a personal residence up to $250,000 ($500,000 if married)to be excluded from taxable income. From a social standpoint, this helps a family afford anew home, but it also helps achieve the economic goal of ensuring that the United Stateshas a mobile workforce.

The use of the income tax as a tool to promote economic and social policies hasincreased in recent years. Realizing this, the beginning tax student can better understand why and how the tax law has become so complex.

Every year, Congress passes laws to assist taxpayers living in disaster areas. Sig-

nificant tax relief was passed in 2010 to assist taxpayers affected by the BP oilspill. The Hurricane Katrina disaster and the September 11, 2001, terroristattacks inspired numerous tax provisions designed to provide immediaterelief to individuals and businesses. An abundance of information related tospecific disaster relief provisions is available at the IRS Web site(www.irs.gov ).

1-2 Chapter 1 The Individual Income Tax Return





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SECTION 1REPORTING AND TAXABLE ENTITIESUnder United States tax law, there are five basic taxable or reporting entities. They areindividuals, corporations, partnerships, estates, and trusts. The taxation of individuals isthe major topic of this text; an overview of the taxation of partnerships and corporationsis presented in Chapters 10 and 11, respectively. Taxation of estates and trusts is a special-ized area not covered in this text.

The Individual The most familiar taxable entity is the individual. Taxable income for individuals generally includes wages, salary, self-employment earnings, rent, interest, and dividends. Individualtaxpayers file Form 1040EZ, Form 1040A, or Form 1040. Form 1040X is used to amendany of these three individual tax returns for changes or errors discovered after filing. Form1040EZ is the simplest tax form, but may be used, in general, only by taxpayers who havethe following characteristics:

1. The taxpayer must be single or married filing a joint return.2. The taxpayer must not be age 65 or over and/or blind.3. The taxpayer must not claim any dependents.

4. The taxpayer’s taxable income must be less than $100,000.5. The taxpayer’s income must include only wages, salaries, unemployment compensa-tion, and not more than $1,500 of taxable interest income.

6. The taxpayer must not have received advance earned income credit payments.

Many taxpayers who cannot file Form 1040EZ file Form 1040A. Generally, Form1040A is filed by taxpayers who are not self-employed and do not benefit from itemizingtheir deductions.

Form 1040, the long form, is used by all individual taxpayers who must file a tax returnand do not qualify to file Form 1040EZ or Form 1040A.

An individual taxpayer’s interest income (over $1,500) and dividend income (over $1,500)are reported on Schedule B of Form 1040 (or Form 1040A, Schedule 1), while self-employment income from a trade or business, other than farm or ranch activities, is includedon Schedule C. Farm or ranch income is reported on Schedule F. The supplemental incomeschedule, Schedule E, is used to report rental or royalty income and pass-through incomefrom partnerships, S corporations, and estates and trusts. If an individual taxpayer has capitalgains or losses, he or she must generally file Schedule D to report those gains or losses.Schedule A is completed by individuals who itemize their deductions. Itemized deductionson Schedule A include medical expenses, certain taxes, certain interest, charitable contribu-tions, casualty and theft losses, and other miscellaneous deductions. These tax forms andschedules and some less common forms are presented in this text.

Self-Study Problem 1.1

Which of the following is not a goal of the income tax system?a. Raising revenue to operate the government.b.Providing incentives for certain business and economic goals, such as higher

employment rates, through business-favorable tax provisions.

c. Providing incentives for certain social goals, such as charitable giving, byallowing tax deductions, exclusions, or credits for selected activities.d.All the above are goals of the income tax system.

Section 1.2 Reporting and Taxable Entities 1-3





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The Corporation Corporations are subject to the United States income tax and must report income annually on Form 1120. The tax rate schedule for corporations is:

Taxable Income Over But Not Over The Tax Is Of the Amount Over

0 $50,000 15% 0$50,000 75,000 $7,500 þ 25% $50,00075,000 100,000 13,750 þ 34% 75,000

100,000 335,000 22,250 þ 39% 100,000335,000 10,000,000 113,900 þ 34% 335,000

10,000,000 15,000,000 3,400,000 þ 35% 10,000,00015,000,000 18,333,333 5,150,000 þ 38% 15,000,00018,333,333 — 6,416,667 þ 35% 18,333,333

Some corporations may elect S corporation status. An S corporation does not pay regularcorporate income taxes; instead, the corporation’s income passes through to the sharehold-ers and is included on their individual returns. Chapter 11 covers the basics of corporatetaxation, including a discussion of S corporations.

The Partnership The partnership is not a taxable entity; instead it is a reporting entity. Generally, all incomeor loss of a partnership is included on the individual tax returns of the partners. However, apartnership must file Form 1065 to report the amount of income or loss and show the allo-cation of the income or loss to the partners. The partners, in turn, report their share of ordinary income or loss on their tax returns. Other special gains, losses, income, anddeductions of the partnership are reported and allocated to the partners separately, sincethe items are given special tax treatment at the partner level. Capital gains and losses,for example, are reported and allocated separately, and the partners report their share onSchedule D of their individual income tax returns. See Chapter 10 for a discussion of part-nerships, including limited partnerships and limited liability companies.

Summary of Major Tax Forms and SchedulesForm or Schedule Description1040EZ Individual return—single and joint filers with no

dependents1040A Individual return, short form1040 Individual return, long form1040X Amended individual returnSchedule A Itemized deductionsSchedule B Interest and dividend incomeSchedule C Profit or loss from business or profession

(Sole Proprietorship)Schedule D Capital gains and lossesSchedule E Supplemental income and loss (rent, royalty, and pass-

through income from Forms 1065, 1120S, and 1041)Schedule F Farm and ranch incomeSchedule L Standard deduction for certain filersSchedule M Making work pay and government retiree credits1041 Fiduciary (estates and trusts) tax return1120 Corporate tax return

(Summary continued on next page)






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1120S S corporation tax return1065 Partnership information returnSchedule K-1 (Form 1065) Partner’s share of partnership results

All of the forms listed here, and more, are available at the IRS Web site( www.irs.gov ).

SECTION 1 THE TAX FORMULA FOR INDIVIDUALSIndividual taxpayers calculate their tax in accordance with a tax formula. Understanding theformula is important, since all tax determinations are based on the result. The formula is:

Gross IncomeDeductions for Adjusted Gross Income

¼ Adjusted Gross IncomeGreater of Itemized Deductions or the Standard DeductionExemptions

¼ Taxable Income Tax Rate (using appropriate tax tables or rate schedules)

¼ Gross Tax Liability Tax Credits and Prepayments

¼ Tax Due or Refund


Indicate which is the most appropriate form or schedule for each of the fol-lowing items. Unless otherwise indicated in the problem, assume the taxpayeris an individual.

ITEM Form or Schedule

1. Bank interest income of $1,600 received by a taxpayerwho itemizes deductions

________________

2. Capital gain on the sale of AT&T stock ________________3. Income from a farm ________________

4. Trust’s income ________________5. An individual partner’s share of partnership income

reported by the partnership________________

6. Salary of $70,000 for a taxpayer who itemizes deductions ________________7. Income from a sole proprietorship business ________________8. Income from rental property ________________9. Dividends of $2,000 received by a taxpayer who does

not itemize deductions________________

10. Income of a large corporation ________________11. Partnership’s loss ________________12. Charitable contribution deduction for an individual

who itemizes deductions________________

13. Single individual with no dependents whose only incomeis $18,000 (all from wages) and who does not itemizedeductions

________________

Section 1.3 The Tax Formula for Individuals 1-5





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Gross Income The calculation of taxable income begins with gross income. Gross income includes allincome, unless the tax law provides for a specific exclusion. The exclusions from grossincome are discussed in Chapter 2.

Deductions for Adjusted Gross Income The first category of deductions includes the deductions for adjusted gross income. Thesedeductions include trade or business expenses, certain reimbursed employee businessexpenses paid under an accountable plan, alimony payments, moving expenses, certain edu-cator expenses, student loan interest, a tuition and fees deduction, the penalty on early withdrawal from savings, and contributions to qualified retirement plans. Later chaptersexplain these deductions in detail.

Adjusted Gross Income The amount of adjusted gross income is sometimes referred to as the ‘‘magic line,’’ since it is the basis for several deduction limitations, such as the limitation on medical expenses. A taxpayer’s adjusted gross income is also used to determine limits on certain charitable con-tributions and contributions to certain individual retirement accounts.

The Wall Street Journal reported: ‘‘Humorist Dave Barry says the IRS is makingprogress in ‘its mission to develop a tax form so scary that merely reading it willcause the ordinary taxpayer’s brain to explode.’ He cites Schedule J, Form 1118:‘‘Adjustments to Separate Limitation (Loss) Categories for Determining Numer-ators of Limitation Fractions, Year-End Recharacterization Balances, and OverallForeign Loss Account Balances.’’

Standard Deduction or Itemized DeductionsItemized deductions are personal items that Congress has allowed as deductions. Includedin this category are medical expenses, certain interest expenses, certain taxes, charitablecontributions, casualty losses, and other miscellaneous items. Taxpayers should itemizetheir deductions only if the total amount exceeds their standard deduction amount. Thefollowing table gives the standard deduction amounts for 2010.

Filing Status 2010 Standard Deduction

Single $ 5,700 Married, filing jointly 11,400 Married, filing separately 5,700Head of household 8,400Qualifying widow(er) 11,400

Taxpayers who are 65 years of age or older or blind are entitled to an additional standarddeduction amount. For 2010, the additional standard deduction amount is $1,400 forunmarried taxpayers and $1,100 for married taxpayers and surviving spouses. Taxpayers who are both 65 years of age or older and blind are entitled to two additional standarddeduction amounts. See Section 1.7 for a complete discussion of the basic and additionalstandard deduction amounts. The itemized deduction amount was phased out for certainhigh-income taxpayers for years prior to 2010. Itemized deductions will not be phasedout in 2010, but the phase-out is expected to resume in 2011. Please see Section 5.7 inChapter 5 for a detailed discussion of the phase-out calculation.






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ExemptionsExemptions are worth $3,650 each for 2010. The two types of exemptions, personal anddependency, are described later in this chapter. In years prior to 2010, the exemptionamount was phased out for high-income taxpayers. Exemptions will not be phased out in 2010. Please see Section 5.7 for a detailed discussion of the phase-out calculation, which is scheduled to resume for tax years beginning in 2011.

The Gross Tax Liability A taxpayer’s gross tax liability is obtained by reference to the tax table or by use of a tax rateschedule. Tax credits and prepayments are subtracted from gross tax liability to calculatethe net tax due the government or the refund due the taxpayer.

Taxpayers may provide information with their individual tax return authorizingthe IRS to deposit refunds directly into their bank account. Taxpayers with a bal-ance due may pay their tax bill with a credit card.

SECTION 1 WHO MUST FILESeveral conditions must exist before a taxpayer is required to file a U.S. income tax return. These conditions primarily relate to the amount of the taxpayer’s income and the tax-payer’s filing status. Figures 1.1 through 1.3 summarize the filing requirements for tax-payers in 2010. If a taxpayer has any nontaxable income, the amount should be excludedin determining whether the taxpayer must file a return.

Taxpayers are also required to file a return if they have net earnings from self-employment of $400 or more, receive advanced earned income credit payments (AEIC), or owe taxes suchas Social Security taxes on unreported tips. When a taxpayer is not required to file but is due

a refund for overpayment of taxes, a return must be filed to obtain the refund. A taxpayer who is required to file a return should mail the return to the appropriate

Internal Revenue Service Center listed in the Form 1040 Instructions and on the IRSWeb site ( www.irs.gov ). Generally, individual returns are due on the fifteenth day of the fourth month of the year following the close of the tax year. For a calendar year tax-payer, therefore, the due date is April 15, unless the taxpayer requests a filing extension. An extension of time to file until October 15 may be requested on Form 4868 by April 15.However, all tax due must be paid by April 15 or penalties and interest will apply. Thefollowing figures summarize the circumstances where tax return filing is required.


Bill is a single taxpayer. In 2010, his salary is $28,500 and he has interestincome of $1,500. In addition, he has deductions for adjusted gross income of$2,100 and he has $6,250 of itemized deductions. If Bill claims one exemptionfor this year, calculate the following amounts:

1. Gross income $ ________________2. Adjusted gross income $ ________________3. Standard deduction or itemized deduction amount $ ________________4. Taxable income $ ________________

Section 1.4 Who Must File 1-7





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FIGURE 1.1 WHO MUST FILE

At the time this went to press, the 2010 forms were not available. The 2009 forms above have been adjusted to include the 2010amounts. To view the final 2010 figures, please go to the Form 1040 Instructions at the IRS Web site ( www.irs.gov ).

FIGURE 1.2






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More than 8 million people file tax returns every year even though their wagesand other income are too low to require filing according to the Treasury InspectorGeneral for Tax Administration (TIGTA). TIGTA estimated that taxpayers spend$390 million and 75 million hours preparing and filing unnecessary tax returnseach year. Therefore, the first step in preparing a tax return should be to deter-mine if the taxpayer is actually required to file.

FIGURE 1.3

At the time this went to press, the 2010 form was not available. The 2009 form above has been adjusted to include the 2010amounts. To view the final 2010 figure, please go to the Form 1040 Instructions at the IRS Web site ( www.irs.gov ).


Indicate by a check mark whether the following taxpayers are required to filea return for 2010 in each of the following independent situations:

Filing Required?Yes No

1. Taxpayer (age 45) is single with income of $8,300. _____ _____2. Husband (age 67) and wife (age 64) have an income of

$18,000 and file a joint return._____ _____

3. Taxpayer is a college student with salary from a part-time job of $6,000. She is claimed as a dependent by her parents.

_____ _____

4. Taxpayer has net earnings from self-employment of $4,000. _____ _____5. Taxpayers are married with income of $15,900 and file a

joint return. They expect a refund of $600 from excesswithholding.

_____ _____

6. Taxpayer is a waiter and has unreported tips of $450. _____ _____7. Taxpayer is a qualifying widow (age 65) with a dependent

son (age 18) and income of $16,800._____ _____

8. Taxpayer has income of $4,500 and is single. His age is 45and he received advanced earned income credit payments.

_____ _____

Section 1.4 Who Must File 1-9





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SECTION 1.5 FILING STATUS AND TAX COMPUTATION An important step in calculating the amount of a taxpayer’s tax is the determination of thetaxpayer’s correct filing status. The tax law has five different filing statuses: single; mar-ried, filing jointly; married, filing separately; head of household; and qualifying widow(er). A tax table that must be used by most taxpayers, showing the tax liability for all five sta-

tuses, is provided in Appendix A. The tax table can be used unless the taxpayer’s taxableincome is $100,000 or over or the taxpayer is using a special method to calculate the taxliability. If taxpayers can use the tax table to determine their tax, they must do so; otherwise, a tax rate schedule is used. Each filing status has a separate tax rate schedule as pre-sented in Appendix A.

Single Filing Status Taxpayers who do not qualify for married, qualifying widow(er), or head of household sta-tus file as single. This status must be used by taxpayers who are unmarried or legally sep-arated from their spouses by divorce or separate maintenance decree as of December 31 of the tax year. State law governs whether a taxpayer is married, divorced, or legally sepa-rated. If a taxpayer’s spouse dies during the year, the taxpayer’s status is married forthat year.

Married, Filing Jointly Taxpayers are considered married for tax purposes if they are married on December 31 of the tax year. Also, in the year of one spouse’s death, the spouses are considered married forthe full year. In most situations, married taxpayers pay less tax by filing jointly than by fil-ing separately. Married taxpayers may file a joint return even if they did not live togetherfor the entire year.

As the law currently stands, same-sex couples cannot file joint returns. The questionoriginally arose when Massachusetts recognized same-sex marriages. For federal tax pur-poses, such marriages are not recognized.

Married, Filing Separately Married taxpayers may file separate returns and should do so if it reduces their total taxliability. They may file separately if one or both had income during the year. If separatereturns are filed, both taxpayers must compute their tax in the same manner. For example,if one spouse itemizes deductions, the other spouse must also itemize deductions. Each tax-payer reports his or her income, deductions, and credits and is responsible only for the taxdue on his or her return. If the taxpayers live in a community property state, they must fol-low state law to determine community income and separate income. The community prop-erty states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas,Washington, and Wisconsin. See Chapter 6 for additional discussion regarding incomeand losses from community property.

A legally married taxpayer may file as head of household (based on the general filing sta-tus rules) if he or she qualifies as an abandoned spouse. A taxpayer qualifies as an aban-doned spouse only if all of the following requirements are met:

1. A separate return is filed,2. The taxpayer paid more than half the cost (rent, utilities, etc.) to maintain his or her

home during the year,






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3. The spouse did not live with the taxpayer at any time in the last 6 months of the year, and

4. For over 6 months during the year the home was the principal residence for a depen-dent child, stepchild, or adopted child. Under certain conditions a foster child may qualify as a dependent.

In certain circumstances, married couples may be able to reduce their total taxliability by filing separately. For instance, since some itemized deductions, such asmedical expenses and casualty losses, are reduced by a percentage of adjustedgross income (discussed in Chapter 5), a spouse with a casualty loss and low sepa-rate adjusted gross income may be better off filing separately.

Head of HouseholdIf an unmarried taxpayer can meet special tests, he or she is allowed to file as head of household. Head of household rates are lower than rates for single or married filing sep-

arately. A taxpayer qualifies for head of household status if both of the following condi-tions exist:

1. The taxpayer was unmarried or abandoned as of December 31 of the tax year, and2. The taxpayer paid more than half of the cost of keeping a home that was the princi-

pal place of residence of a dependent child or other qualifying dependent relative. An unrelated dependent or a dependent, such as a cousin, who is too distantly related, will not qualify the taxpayer for head of household status. If the dependent is the taxpayer’s parent, the parent need not live with the taxpayer. In all cases otherthan dependent parents, who may maintain a separate residence, the qualifyingdependent-relative must actually live in the same household as the taxpayer. A divorced parent who meets the above requirements, but has signed an IRS form or

legal agreement shifting the dependency deduction to his or her ex-spouse, may stillfile using head of household status.

Divorcing couples may save significant taxes if one or both of the spousesqualifies as an ‘‘abandoned spouse’’ and can use the head of household filingstatus. The combination of head of household filing status for one spouse withmarried filing separately filing status for the other spouse is commonly seen inthe year (or years) leading up to a divorce. In cases where each spouse hascustody of a child, the separated taxpayers may each claim head of householdstatus.

Qualifying Widow(er) with Dependent Child A taxpayer may continue to benefit from the joint return rates for 2 years after the death of his or her spouse. To qualify to use the joint return rates, the widow(er) must pay over half the cost of maintaining a household where a dependent child, stepchild, adopted child, orfoster child lives. After the 2-year period, these taxpayers usually qualify for the head of household filing status.

Section 1.5 Filing Status and Tax Computation 1-11





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Tax Computation

The laws for tax year 2010 are covered in this text. After 2010, many of the taxlaws passed between 2001 and 2009 will ‘‘sunset’’ or ‘‘self-destruct.’’ As we goto press, the tax rate structure described below, including the rates for quali-fied dividends and capital gains, (discussed in Section 1.8 and Chapter 8) willend on December 31, 2010. In 2011, we may see a reversion to rates in effecta decade ago or, more likely, Congress will pass new laws, possibly extendingsome of the rates in effect in 2010.

For 2010, there are six income tax brackets (10 percent, 15 percent, 25 percent, 28 per-cent, 33 percent, and 35 percent). The individual tax rates for 2010 are presented in the taxrate schedules in Appendix A. The tax rate schedule for single taxpayers is summarizedbelow:

Single Tax Rate Schedule

If taxable incomeis over--

But notover-- The tax is:

-0- $8,375 10% of the amount over $0

$8,375 $34,000 $837.50 plus 15% of the amount over $8,375

$34,000 $82,400 $4,681.25 plus 25% of the amount over $34,000



$373,650 no limit $108,421.25 plus 35% of the amount over $373,650

When calculating their tax liability, taxpayers who had adjusted gross income in excessof threshold amounts were required to reduce the amount of their otherwise allowable per-sonal exemptions and itemized deductions in years prior to 2010. The provisions for reduc-ing exemptions and itemized deduction amounts resulted in a marginal tax rate that wasslightly higher than the official maximum 35 percent rate.

The tax rates applicable to net long-term capital gains currently range from 0 percent to28 percent depending on the taxpayer’s tax bracket and the kind of capital asset. The cal-culation of the tax on capital gains is discussed in detail in Chapter 8, and the applicable taxrates are discussed in Section 1.8 of this chapter.

The 2003 and 2006 Tax Acts introduced new lower rates for qualifying dividends,discussed in detail in Chapter 2, effective for tax years before 2011. The tax rates on div-idends are as follows through 2010:

Qualifying Dividend RateOrdinary Tax Bracket 2003–2007 2008–2010

10% and 15% 5% 0%Higher brackets 15% 15%






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EXAMPLE Carol, a single taxpayer claiming one exemption, has adjusted grossincome of $120,000 and taxable income of $105,000 for 2010. Her tax iscalculated using the 2010 tax rate schedule from Appendix A as follows:

$23,109 ¼ $16,781 þ 28% ($105,000 $82,400)

EXAMPLE Meg is a single taxpayer during 2010. Her taxable income for the yearis $27,530. Using the tax table in Appendix A, her gross tax liabilityfor the year is found to be $3,710.

Taxpayers considering marriage may be able to save thousands of dollars byengaging in tax planning prior to setting a date. If the couple would pay less intaxes by filing as married rather than as single (which will frequently happen ifone spouse has low earnings for the year), they may prefer a December wedding.They can take advantage of the rule that requires taxpayers to file as married forthe full year even if they were married on the last day of the year. On the otherhand, if filing a joint return would cause the couple to pay more in taxes (whichfrequently happens if both spouses have high incomes), they may prefer a Janu-ary wedding.

Making Work Pay CreditFor 2009 and 2010, the Making Work Pay credit provides a refundable tax credit, intendedto help individuals and families and to stimulate the economy. The amount of the credit is upto $400 for working individuals and $800 for married taxpayers filing joint returns. The taxcredit is 6.2 percent of earned income up to $6,451 (or $12,903 if married filing jointly) andis phased-out for taxpayers with modified adjusted gross income in excess of $75,000 or$150,000 for married couples filing jointly. The phase-out calculation is as follows:

The $400 credit is phased out at 2 percent of Modified AGI between $75,000 and$95,000 (i.e., 2% ($95,000 $75,000) ¼ $400).

The $800 credit is phased out at 2 percent of Modified AGI between $150,000 and$190,000 (i.e., 2% ($190,000 $150,000) ¼ $800).

The Making Work Pay credit is available to both employees and self-employed individ-uals. Taxpayers who can be claimed as a dependent on someone else’s tax return are not eligible for the credit. Thus, for example, students claimed as a dependent on their parent’s(parents’) tax return will not be allowed to claim the Making Work Pay credit.

Most wage earners benefited with a larger paycheck because of the changes made to thefederal income tax withholding tables when the Making Work Pay credit was added tothe law. The reduced withholding resulted in an immediate infusion of extra cash to wage earners during 2009 and 2010. The credit is intended to offset the reduced withhold-ing claimed when taxpayers file their 2009 and 2010 tax returns. Self-employed taxpayers who do not have taxes withheld by an employer during the year can claim the benefit of thecredit on their tax return. Taxpayers calculate the Making Work Pay credit on Schedule Mof Form 1040A and Form 1040.

EXAMPLE Peter is single and earns $50,000 in wages during 2010. He has noother income or expenses. His $400 Making Work Pay credit is calcu-lated on Schedule M on page 1-15.

Section 1.5 Filing Status and Tax Computation 1-13





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SECTION 1.6 PERSONAL AND DEPENDENCY EXEMPTIONS Taxpayers are allowed two types of exemptions: personal and dependency. For 2010, eachexemption reduces adjusted gross income by $3,650. In years prior to 2010, the exemptiondeduction was phased out for high-income taxpayers. Please see Chapter 5 for a detaileddiscussion of the phase-out calculations for exemptions and itemized deductions in effect prior to 2010. These rules are expected to be reinstated in 2011.

Personal Exemptions

Personalexemptionsaregrantedtotaxpayersforthemselves;almostalltaxpayersandspousesareen-titledto onepersonalexemptioneach.Childrenwhomaybeclaimedasdependentsontheirparents’tax returns are not allowed toclaim a personalexemption for themselveson their own tax returns.

The IRS started requiring the disclosure of Social Security numbers for each depen-dent claimed by a taxpayer to stop dishonest taxpayers from making up extradependents or even claiming pets. Before this change, listing phony dependentswas one of the most common forms of tax fraud. Reportedly, 7 million depend-ents disappeared from the tax rolls after Congress required taxpayers to includedependents’ Social Security numbers on tax returns.

Dependency ExemptionsDependency exemptions are granted for each person other than the taxpayer or spouse whoqualifies as a dependent. A dependent is an individual who meets the tests discussed belowto be considered either a qualifying child or a qualifying relative.

Qualifying ChildFor a child to be a dependent, he or she must meet the following tests:1. Relationship Test

The child must be the taxpayer’s child, stepchild, or adopted child, or the taxpayer’sbrother or sister, half brother or half sister, or stepsibling, or a descendant of any


Indicate the filing status (or statuses) in each of the following independentcases, using this legend:

A – Single D – Head of householdB – Married, filing a joint return E – Qualifying widow(er)C – Married, filing separate returns

Case Filing Status

1. The taxpayers are married on December 31 of the tax year. ____________2. The taxpayer is single, with a dependent child living in her home. ____________3. The taxpayer is unmarried and is living with his girlfriend. ____________4. The taxpayer is married and his spouse left midyear and has

disappeared. The taxpayer has no dependents.____________

5. The unmarried taxpayer supports her dependent mother,who lives in her own home.

____________

6. The taxpayer’s wife died last year. His 15-year-old dependentson lives with him.

____________






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Peter Smith

x

x

x

400

50,000 75,000

400

400

-0-

123 6789 45

Section 1.6 Personal and Dependency Exemptions 1-15





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of these. Under certain circumstances, a foster child can also qualify. The child must be younger than the person claiming him or her unless the child is permanently disabled.

2. Domicile Test The child must have the same principal place of abode as the taxpayer for more thanhalf of the taxable year. In satisfying this requirement, temporary absences from the

household due to special circumstances such as illness, education, and vacation arenot considered.

3. Age Test The child must be under age 19 or a full-time student under the age of 24. A child isconsidered a full-time student if enrolled full-time for at least 5 months of the year. Thus, a college senior graduating in May or June can qualify in the year of graduation.

4. Joint Return Test The child must not file a joint return with his or her spouse. If neither the spousenor the child is required to file, but they file a return merely to claim a refund of tax,they are not considered to have filed a return for purposes of this test.

5. Citizenship Test The dependent must be a United States citizen, a resident of the United States, Canada,or Mexico, or an alien child adopted by and living with a United States citizen.

6. Self-Support Test A child who provides more than one-half of his or her own support cannot beclaimed as a dependent of someone else. Support includes expenditures for suchitems such as food, lodging, clothes, medical and dental care, and education. Tocalculate support, the taxpayer uses the actual cost of the above items, except lodging. The value of lodging is calculated at its fair rental value. Funds received by studentsas scholarships are excluded from the support test.

In the event that a child satisfies the requirements of dependency for more than one tax-payer, the following tie-breaking rules apply:

If one of the individuals eligible to claim the child is a parent, that person will beallowed the exemption.

If both parents qualify (separate returns are filed), then the parent with whom the childresides the longest during the year prevails. If the residence period is the same or is not ascertainable, then the parent with the highest AGI (Adjusted Gross Income) prevails.

If no parents are involved, the taxpayer with the highest AGI prevails.

EXAMPLE Bill, age 12, lives in the same household with Irene, his mother, andDarlene, his aunt. Bill qualifies as a dependent of both Irene andDarlene. Since Irene is Bill’s mother, she has the right to claim Bill as adependent. The tie-breaking rules are not necessary if the taxpayerwho would get the exemption does not claim the exemption. Hence,Darlene can claim Bill as a dependent if Irene does not claim him.

In the case of divorced or legally separated parents with children, the dependency exemption for a child belongs to the parent with whom the child lived for more than6 months out of the year. The exemption can be shifted to the noncustodial parent if the custodial parent signs the appropriate IRS form or legal agreement.

Figure 1.4 illustrates the interaction of the qualifying child dependency tests describedabove.






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FIGURE 1.4 DEPENDENCY EXEMPTION TESTSFLOW CHART FOR QUALIFYING CHILD

Yes

Yes

Yes

No

NODEPENDENCY

EXEMPTION

DEPENDENCY EXEMPTION

Yes

Yes

No

No

No

No

Yes

Was the domiciletest met?

Was therelationshiptest met?

Was the joint return

test met?

Is the child under19 or a full-time

student under 24?

START

No

U.S. Citizen orresident of U.S.,

Mexico, Canada?

Was the support test met?






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Qualifying Relative A person who is not a qualifying child can be a qualifying relative if the following five-part test is met. A child of a taxpayer who does not meet the tests to be a qualifying child canstill qualify as a dependent under the qualifying relative tests described below.

1. Relationship or Member of Household Test

The individual must either be a relative of the taxpayer or a member of the household. The list of qualifying relatives is broad and includes parents, grandparents, children, grand-children, siblings, aunts and uncles by blood, nephews and nieces, ‘‘in-laws,’’ and adoptedchildren. Foster children may also qualify in certain circumstances. If the potential depen-dent is a more distant relative, additional information is available at the IRS Web site( www.irs.gov ). For example, cousins are not considered relatives for this purpose.

In addition to the relatives listed above, any person who lived in the taxpayer’s home as amember of the household for the entire year meets the relationship test. A person is not considered a member of the household if at any time during the year the relationshipbetween the taxpayer and the dependent was in violation of local law.

EXAMPLE Scott provides all of the support for an unrelated family friend wholives with him for the entire tax year. He also supports a cousin wholives in another state. The family friend can qualify as Scott’s depen-dent, but the cousin cannot. The family friend meets the member ofthe household test. Even though the cousin is not considered a rela-tive, he could have been a dependent if he met the member of thehousehold part of the test.

2. Gross Income Test The individual cannot have gross income equal to or above the exemption amount ($3,650 in 2010).

3. Support Test The dependent must receive over half of his or her support from the taxpayer or agroup of taxpayers (see multiple support agreement below).

4. Joint Return Test The dependent must not file a joint return unless it is only to claim a refund of taxes.

5. Citizenship Test The dependent must meet the citizenship test.

EXAMPLE A taxpayer has a 26-year-old son with gross income less than the exemp-tion amount who receives more than half his support from his parents.The son fails the test to be a qualifying child based on his age, but passesthe test to be a dependent based on the qualifying relative rules.

Figure 1.5 illustrates the qualifying relative tests described above. A taxpayer can claim an exemption for a dependent who was born or died during the year if the dependency tests were met while that person was alive. A dependency exemptionmay be claimed for a baby born on or before December 31. Taxpayers must provide aSocial Security number for all dependents.

If a dependent is supported by two or more taxpayers, a multiple support agreement may be filed. To file the agreement, the taxpayers (as a group) must provide over 50 per-cent of the support of the dependent. Assuming that all other dependency tests are met, thegroup may give the exemption to any member of the group who provided over 10 percent of the dependent’s support.






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FIGURE 1.5 DEPENDENCY EXEMPTION TESTSFLOW CHART FOR QUALIFYING RELATIVE

Yes

Yes

Yes

No

NODEPENDENCY

EXEMPTION

DEPENDENCY EXEMPTION

Yes

No

No

No

No

Yes

Was the support test met?

U.S. Citizen orresident of U.S.,

Mexico, Canada?

Was the joint return test

met?

Was the relationshipor member of house-

hold test met?

Is gross incomeless than $3,650

(for 2010)?

START






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Indicate in each of the following independent situations the number ofexemptions the taxpayer should claim on their 2010 income tax returns. If atest is not mentioned, you should consider that it is met.

______ 1. Abel is 72 years old and married. His wife is 64 and meets the test forblindness. How many exemptions should they claim on a joint return?

______ 2. Betty and Bob are married and have a 4-year-old son. During the yearBetty gave birth to a baby girl. How many exemptions should Bettyand Bob claim on a joint return?

______ 3. Charlie supports his 26-year-old brother, who is a full-time student.His brother’s gross income is $4,500 from a part-time job. How manyexemptions should Charlie claim on his return?

______ 4. Donna and her sister support their mother and provide 60 percent ofher support. If Donna provides 25 percent of her mother’s supportand her sister signs a multiple support agreement giving Donna theexemption, how many exemptions should Donna claim on her return?

______ 5. Frank is single and supports his son and his son’s wife, both of whomlived with him for the entire year. The son (age 20) and his wife (age19) file a joint return to get a refund, reporting $2,500 ($2,000 earnedby the son) in gross income. Both the son and daughter-in-law are full-time students. How many exemptions should Frank claim on his return?

______ 6. Gary is single and pays $5,000 towards his 20-year-old daughter’s col-lege expenses. The remainder of her support is provided by a $9,500tuition scholarship. The daughter is a full-time student. How manyexemptions should Gary claim on his return?

______ 7. Helen is 50 years old and supports her 72-year-old mother, who isblind and has no income. How many exemptions should Helen claimon her return?

Your clients, Adam and Amy Accrual, have a 21-year-old daughter namedApril. April is single and is a full-time student studying for her bachelor’sdegree in accounting at California Poly Academy (CPA) in Pismo Beach, Califor-

nia, where she lives with her roommates year-round. Last year April worked ata local bar and restaurant 4 nights a week and made $18,000, which she usedfor tuition, fees, books, and living expenses. Her parents help April by sendingher $300 each month to help with her expenses at college. This is all of thesupport given to April by her parents. When preparing Adam and Amy’s taxreturn you note that they claim April as a dependent for tax purposes. Adam isinsistent that they can claim April because of the $300 per month support andthe fact that they ‘‘have claimed her since she was born.’’ He will not let youtake April off his return as a dependent. Would you sign the Paid Preparer’sdeclaration (see example above) on this return? Why or why not?






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SECTION 1 THE STANDARD DEDUCTION The standard deduction was placed in the tax law to provide relief for taxpayers with fewitemized deductions. The amount of the standard deduction is subtracted from adjustedgross income by taxpayers who do not itemize their deductions. If a taxpayer’s grossincome is less than the standard deduction amount, the taxpayer has no taxable income.

The standard deduction amounts are presented below: Filing Status 2010 Standard Deduction

Single $ 5,700 Married, filing jointly 11,400 Married, filing separately 5,700Head of household 8,400Qualifying widow(er) 11,400

Taxpayers may be able to reduce taxes by itemizing deductions on Schedule Aof Form 1040 rather than claiming the standard deduction. The U.S. GeneralAccounting Office has estimated that close to a billion dollars a year may be lostby taxpayers who failed to itemize their deductions.

Additional Amounts for Old Age and Blindness Taxpayers who are 65 years of age or older or blind are entitled to an additional standarddeduction amount. For 2010, the additional standard deduction amount is $1,400 forunmarried taxpayers and $1,100 for married taxpayers and qualifying widows or widowers. Taxpayers who are both at least 65 years old and blind are entitled to two additional stan-dard deduction amounts. The additional standard deduction amounts are also available forthe taxpayer’s spouse, but not for dependents. An individual is considered blind for pur-poses of receiving an additional standard deduction amount if:

1. Central visual acuity does not exceed 20/200 in the better eye with correctinglenses, or

2. Visual acuity is greater than 20/200 but is limited to a field of vision not greater than20 degrees.

EXAMPLE John is single and 70 years old in 2010. His standard deduction is$7,100 ($5,700 plus an additional $1,400 for being 65 years of age orolder).

EXAMPLE Bob and Mary are married in 2010 and file a joint return. Bob is age68, and Mary is 63 and meets the test for blindness. Their standarddeduction is $13,600 ($11,400 plus $1,100 for Bob being 65 years or

older and another $1,100 for Mary’s blindness).

For 2008 and 2009, and likely 2010 if the law is extended as expected, taxpayersare allowed an addition to the standard deduction amounts shown above ifthey paid property taxes on a principal residence. The additional standarddeduction amount is limited to the lesser of $500 ($1,000 for joint filers) orreal estate taxes paid. This addition to the standard deduction is coveredmore fully in Chapter 5. Please see the Whittenburg Web site for informationon laws pending as we go to press.

Section 1.7 The Standard Deduction 1-21





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Individuals Not Eligible for the Standard Deduction The following taxpayers cannot use the standard deduction, but must itemize instead:

1. A married individual filing a separate return, whose spouse itemizes deductions.2. A nonresident alien.3. An individual filing a short-period tax return because of a change in the annual

accounting period.EXAMPLE Ed and Ann are married individuals who file separate returns for

2010. Ed itemizes his deductions on his return. Ann’s adjusted grossincome is $12,000, and she has itemized deductions of $900. Ann’staxable income is calculated as follows:

Adjusted gross income $12,000Itemized deductions (900)Exemption amount (3,650)Taxable income $ 7,450

Since Ed itemizes his deductions, Ann must also itemize deductionsand is not entitled to use the standard deduction amount.

Special Limitations for Dependents The standard deduction is limited for the tax return of a dependent. The total standarddeduction may not exceed the greater of $950 or the sum of $300 plus the dependent’searned income up to the basic standard deduction amount in total (for example, $5,700for single taxpayers), plus any additional standard deduction amount for old age or blind-ness. The standard deduction amount for old age and blindness is only allowed when adependent files a tax return. It is not allowed to increase the standard deduction of the tax-payer claiming the dependent. Also, remember that a dependent may not claim a personalexemption on his or her own return.EXAMPLE Penzer, who is 4 years old, earned $6,500 as a child model during 2010. A

dependency exemption for Penzer is claimed by his parents on their taxreturn. Penzer is required to file a tax return, and his taxable income willbe $800 ($6,500 less $5,700, the standard deduction amount). He is notallowed to claim an exemption for himself. If Penzer had earned only $400,his standard deduction would be $950 (the greater of $950 or $700 [$400 þ$300]) and he would not owe any tax or be required to file a return.


Indicate in each of the following independent situations the amount of the stan-dard deduction the taxpayers should claim on their 2010 income tax returns.

______ 1. Adam is 45 years old, in good health, and single.

______ 2. Bill and Betty are married and file a joint return. Bill is 66 years old,and Betty is 60.______ 3. Charlie is 70, single, and blind.______ 4. Debbie qualifies for head of household filing status, is 35 years old,

and is in good health.______ 5. Elizabeth is 9 years old, and her only income is $3,600 of interest on a sav-

ings account. She is claimed as a dependent on her parents’ tax return.______ 6. Frank and Freida are married with two dependent children. They file a joint

return, are in good health, and both of them are under 65 years of age.






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In the spring of 2010, Congress passed health care legislation with the goal ofproviding coverage over the next several years for many millions of Americanswho are currently not covered by health insurance. This may be one of the mostsignificant pieces of social legislation passed in our lifetime, and much of it isadministered and enforced through our tax system. The following is a summaryof some tax elements of the health care legislation and the phase-in dates:

Tax Rates Beginning in 2013, high-income taxpayers (modified AGI over$200,000 for single taxpayers and over $250,000 for married taxpayers) willbe subject to a new Medicare tax on most income. Please see Sections 4.10,9.3, and 9.6 for coverage of the Medicare tax in 2010. The 2013 tax will be anadditional .9 percent on most earned income which is already subject to theMedicare tax, and an additional 3.8 percent on most investment income, includ-ing capital gains, interest, dividends and rental income. Distributions from IRAsand retirement plans and municipal bond interest will be exempt from this tax.

Extended Coverage for Adult Children Beginning in 2010, any health planwhich covers dependents must be extended to allow for coverage of mostunmarried adult children through age 26.

Small Employer Health Insurance Credit In 2010, small employers will be

allowed a credit for health insurance provided to workers who are not ownersand who meet certain criteria. This credit will continue with differing require-ments through 2015.

Itemized Deduction Threshold Increases Beginning in 2013, the AGI thresh-old for deducting medical expenses as an itemized deduction will increase from7.5 percent to 10 percent of AGI, with a temporary reprieve for seniors age 65or older.

Refundable Premium Assistance Credit Beginning in 2014, a tax returncredit will be allowed to help subsidize the purchase of health insurancethrough new health benefit ‘‘exchanges’’ for certain low-income taxpayers.

Tax Return Penalty for Failure to Maintain Coverage Beginning in 2014, tax-payers must have qualifying health coverage for themselves and their depend-ents or be subject to a penalty which will be reported and paid on their

personal tax return.‘‘Play or Pay’’ Penalty for Large Employers Not Offering Required HealthInsurance Beginning in 2014, large employers will be assessed penalties fornot offering health coverage. The calculation of the penalty is complex anddepends on many variables such as type of coverage provided by the employerand income levels of the employees.

SECTION 1 A BRIEF OVERVIEW OF CAPITAL GAINS AND LOSSESWhen a taxpayer sells an asset, there is normally a gain or loss on the transaction. Depend-ing on the kind of asset sold, this gain or loss will have different tax consequences. Chapter

8 of this text has detailed coverage of the effect of gains and losses on a taxpayer’s tax lia-bility. Because of their importance to the understanding of the calculation of an individual’stax liability, however, a brief overview of gains and losses will be discussed here.

The amount of gain or loss realized by a taxpayer is determined by subtracting theadjusted basis of the asset from the amount realized . Generally, the adjusted basis of anasset is its cost less any depreciation (covered in Chapter 7) taken on the asset. The amount realized is generally what the taxpayer receives from the sale (e.g., the sales price less any cost of the sale). The formula for calculation of gain or loss can be stated as follows:

Gain (or loss) ¼ Amount realized Adjusted basis

Section 1.8 A Brief Overview of Capital Gains and Losses 1-23





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Most gains and losses realized are also recognized for tax purposes. That is, most gainsor losses that occur are included in the taxpayer’s taxable income. The exceptions to thisgeneral tax recognition rule are discussed in Chapter 8.

EXAMPLE Lisa purchased a rental house a few years ago for $100,000. Totaldepreciation to date on the house is $25,000. In the current year shesells the house for $155,000 and receives $147,000 after paying sellingexpenses of $8,000. Her gain on the sale is $72,000 calculated as follows:

Amount realized ($155,000 $8,000) $147,000Adjusted basis ($100,000 $25,000) 75,000Gain realized $ 72,000

This gain realized will be recognized as a taxable gain.

Capital Gains and LossesGains and losses can be either ordinary or capital . Ordinary gains and losses are treated for taxpurposes just like other items such as salary and interest, and they are taxed at ordinary rates.

Ingeneral,a capital asset isanyproperty (either personal or investment)held bya taxpayer,withcertain exceptions as listed in the tax law (see Chapter 8). Typicalassets that are not capital assetsare inventory and accounts receivable. Examples of capital assets held by individual taxpayersinclude stocks, bonds, land, cars, boats, and other items held as investments or for personal use.

The rates on long-term (held more than 12 months) capital gains are summarized as follows:

Ordinary Tax Bracket 2010 Capital Gains Tax Rate

10% and 15% 0% All others 15%

Gain from property held 12 months or less is deemed to be short-term capital gain andis taxed at ordinary income tax rates (i.e., up to a maximum rate of 35 percent in 2010).EXAMPLE In 2010, Chris sells AT&T stock for $25,000. He purchased the stock

5 years ago for $15,000, giving him an adjusted basis of $15,000 anda long-term gain of $10,000. Chris’ taxable income without the sale ofthe stock is $190,000, which puts him in the 33 percent tax bracket.The tax due on the long-term capital gain would be $1,500 (15% $10,000) instead of $3,300 (33% $10,000) if the gain on the stockwere treated as ordinary income.

When calculating gain or loss, the taxpayer must net all capital asset transactions todetermine the nature of the final gain or loss (see Section 8.4 for a discussion of this cal-culation). If an individual taxpayer ends up with a net capital loss (short-term or long-term), up to $3,000 per year can be deducted against ordinary income. The net loss not used in the current year may be carried forward and used to reduce taxable income infuture years (see Section 8.5 for a discussion of capital losses). Losses from capital assetsheld for personal purposes, such as a non-business auto or a personal residence, are not deductible, even though gains on personal assets are taxable.

Taxpayers may wish to postpone the sale of capital assets until the holdingperiod is met to qualify for the preferential long-term capital gains rate. Ofcourse, there is always the risk that postponing the sale of a capital asset such asstock may result in a loss if the price of the stock decreases below its cost duringvolatile markets. The economic risks of a transaction should always be consideredalong with the tax benefits.






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EXAMPLE Amy purchased gold coins as an investment. She paid $50,000 for thecoins. This year she sells the coins to a dealer for $35,000. As a result,Amy has a $15,000 capital loss. She may deduct $3,000 of the lossagainst her other income this year. The remaining unused loss of$12,000 ($15,000 $3,000) is carried forward and may be deductedagainst other income in future years. Of course, the carryover issubject to the $3,000 annual limitation in future years.

Volunteer Income Tax Assistance Program (VITA) Many universities and colleges run VITA sites in conjunction with their accounting pro-grams. This is a small but vital part of the VITA program run by the IRS. The majority of the VITA sites are not run by schools, but rather by community groups, such aschurches, senior groups (AARP), military bases, etc. If a student has a chance to participatein a VITA program, he or she should do so if at all possible. The experience provides val-uable insight into preparing tax returns for others.

The following is a brief description of the program from the IRS Web site(www.irs.gov): The VITA Program offers free tax help to low-to-moderate-income (gen-erally, $49,000 and below) people who cannot prepare their own tax returns. Certified vol-unteers sponsored by various organizations receive training to help prepare basic taxreturns in communities across the country. VITA sites are generally located at community and neighborhood centers, libraries, schools, shopping malls, and other convenient loca-tions. Most locations also offer free electronic filing. Please see the IRS Web site to locatethe nearest VITA site and for more information.

SECTION 1 TAX AND THE INTERNET Taxpayers and tax practitioners can find a substantial amount of useful information on theInternet. The Internet is a global communication system that connects millions of com-puters throughout the world. Government agencies, businesses, organizations, and groups(e.g., the IRS, H&R Block, and Cengage Learning) maintain sites that contain informationof interest to the public.

The information available on various Web sites is subject to rapid change. Discussedbelow are some current Internet sites that are of interest to taxpayers. Taxpayers shouldbe aware that the locations and information provided on the Internet are subject to changeby the site organizer without notice.


Erin purchased stock in JKL Corporation several years ago for $8,750. In thecurrent year, she sold the same stock for $12,800. She paid a $200 salescommission to her stockbroker.

1. What is Erin’s amount realized? $ ______________2. What is Erin’s adjusted basis? $ ______________3. What is Erin’s realized gain or loss? $ ______________4. What is Erin’s recognized gain or loss? $ ______________5. How is any gain or loss treated for tax purposes?

________________________________________________________________________________________________________________________________________________________________________________________________________________________

Section 1.9 Tax and the Internet 1-25





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The IRS site, www.irs.gov One of the most useful sites containing tax information is the one maintained by the IRS. There are several places a taxpayer can enter the IRS site. Entering the main IRS siteshown above and clicking on Site Map provides one of the best entrances because it allowsthe user to quickly scan information available from the IRS. Once a user has reached this Inter-net page, he or she is provided quick links to other useful pages contained within the IRS site.

In addition, the IRS site has a search function to assist users in locating information. The Forms and Publications ( www.irs.gov/formspubs/index.html ) search function isparticularly useful and allows the user to locate and download almost any tax form orpublication available from the IRS. A help function is available to aid users of the IRSsite. E-mail access to the IRS is provided for users who have questions or want to commu-nicate with the IRS. The IRS has also launched a YouTube video site and an iTunes pod-cast site. The YouTube site has numerous educational videos including a series called‘‘Your Guide to an IRS Audit’’ and others describing IRS careers, such as ‘‘Special Agent’’ and ‘‘Revenue Agent.’’

H&R Block, www.hrblock.com Another excellent Internet site for taxpayers is the one maintained by the computer taxsoftware company, H&R Block. The Tax Tips section of the site contains informationon law changes, tax planning, tax terms, and more.

Will Yancey’s home page, www.willyancey.com This site is one of the best indexes available with links to other tax, accounting, and legalInternet sites. The site has hundreds of links to commercial Web sites, federal government Web sites, state and local Web sites, and international Web sites.

Many states are using Web sites to post names of delinquent taxpayers. Sup-porters of ‘‘Internet Shaming’’ say it is an inexpensive way to encourage delin-quent taxpayers to pay their taxes. Apparently, the threat of exposure is a good

motivator. Some critics, however, wonder how innocent taxpayers will be com-pensated when inevitable mistakes are made. O. J. Simpson was listed amongCalifornia’s worst tax debtors on the state‘s public shaming Web site until hewas convicted of leading an armed holdup and sent to prison. Pamela Andersonwas included on the tax delinquents list in 2010 ( www.ftb.ca.gov/individuals/txdlnqnt.shtml ).


Indicate whether the following statements are true or false by circling theappropriate letter.

T F 1. The Internet is controlled by the Federal Communications Com-mission, which is part of the administrative branch of the UnitedStates government.

T F 2. Taxpayers can download tax forms and IRS publications fromthe IRS Internet site.

T F 3. A help function is available to aid users of the IRS site.T F 4. The H&R Block Internet site is maintained by Practitioner’s Pub-

lishing Co. for users of its textbooks.






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SECTION 1.1ELECTRONIC FILING (e-Filing)In Transition: The electronic filing rules discussed below are in constant transition as the IRS works to convert as many taxpayers as possible to electronic filing. Addi-tional information is available at the IRS Web site (www.irs.gov).

Electronic filing (e-filing) is the process of transmitting federal income tax return infor-

mation to the IRS Service Center using a computer with Internet access. For the taxpayer,electronic filing offers a faster refund, either through a direct deposit to the taxpayer’s bank account or by check. IRS statistics show an error rate of less than 1.0 percent on electron-ically filed returns, compared with more than 20 percent on paper returns.

Electronic filing of individual income tax returns may be done with the IRS by usingone of two methods.

The first electronic filing method is e-filing using a personal computer and tax prepa-ration software. Individual taxpayers may transmit their returns from home, workplaces,libraries, or retail outlets. The IRS Web site contains detailed information on this processas the IRS is constantly working to make e-filing more user friendly and widely available.

The IRS recently issued new warnings to taxpayers about identity theft scamswhere information is obtained from taxpayers through fake e-mail notices.The e-mails look official and request detailed personal information. However,the IRS never sends unsolicited e-mails asking for personal information.

The second e-filing option is use of the services of a tax professional, including certifiedpublic accountants, tax attorneys, IRS-enrolled agents, and tax preparation businesses qual-ifying for the IRS tax professional e-filing program.

Electronic filing represents the major significant growth area in computerized tax services. More than two-thirds of all individual taxpayers now e-file. In the future, electronic filing will likely become mandatory for the entire professional tax return preparation industry.

General Electric Co. filed a 24,000-page return electronically in the summer of2006, the first year certain large corporations were required to file electroni-cally. The size of the e-filed return was 237 megabytes. If GE had sent paperforms, the return would have been 8 feet tall.


Indicate whether the following statements are true or false by circling theappropriate letter.

T F 1. Compared to paper returns, electronic filings significantly reducethe error rate for tax returns filed.

T F 2. Individuals may not use electronic filing for their own personal taxreturns, but must engage a tax professional if they wish to e-file.

T F 3. Taxpayers who e-file generally receive faster refunds.T F 4. Taxpayers who e-file can only request their refund in the form of a

check.

Section 1.10 Electronic Filing (e-Filing) 1-27





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KEY POINTS

Learning Objectives Key Points

LO 1.1:

Understand the history andobjectives of U.S. tax law.

The income tax was authorized by the Sixteenth Amendment to the Constitution onMarch 1, 1913. In addition to raising money to run the government’s programs, the income tax is used asa tool of economic and social policies. Examples of economic tax provisions are the limited allowance for expensing capital expen-ditures and the accelerated cost recovery system (ACRS or MACRS) of depreciation. Thecharitable contribution deduction is an example of a social tax provision.

LO 1.2:

Describe the different entitiessubject to tax and reportingrequirements.

Individual taxpayers file Form 1040EZ, Form 1040A, or Form 1040. Corporations must report income annually on Form 1120 and pay taxes. An S corporation generally does not pay regular corporate income taxes; instead, thecorporation’s income passes through to its shareholders and is included on their individ-ual tax returns. A partnership files Form 1065 to report the amount of income or loss and show the

allocation of the income or loss to the partners. Generally, all income or loss of a partnership is included on the tax returns of the partners.

LO 1.3:

Understand and apply the taxformula for individuals.

AGI (adjusted gross income) is gross income less deductions for adjusted gross income. AGI less the larger of itemized deductions or the standard deduction and less exemptionamounts equals taxable income. Appropriate tax tables or rate schedules are applied to taxable income to calculate thegross tax liability. The gross tax liability less credits and prepayments equals the tax due or refund due.

LO 1.4:

Identify individuals who must filetax returns and select their correctfiling status.

Conditions relating to the amount of the taxpayer’s income and filing status must existbefore a taxpayer is required to file a U.S. income tax return. Taxpayers are also required to file a return if they have net earnings from self-employmentof $400 or more, receive advanced earned income credit payments (AEIC), or owe taxessuch as Social Security taxes on unreported tips. There are five filing statuses: single; married, filing jointly; married, filing separately; headof household; and qualifying widow(er).

LO 1.5:

Calculate the number of exemp-tions and the exemption amountsfor taxpayers.

Taxpayers are allowed two types of exemptions: personal and dependency. For 2010, each exemption reduces adjusted gross income by $3,650. Prior to 2010, high-income taxpayers were subject to phase-outs of both exemptions and itemized deductions.The phase-outs may be reinstated in 2011. Personal exemptions are granted to taxpayers for themselves and their spouse. Extra exemptions may be claimed for each person other than the taxpayer or spouse who

qualifies as a dependent. A dependent is an individual who is either a qualifying child or aqualifying relative.

LO 1.6:

Calculate the correct standard oritemized deduction amounts fortaxpayers.

The standard deduction was placed in the tax law to provide relief for taxpayers with fewitemized deductions. For 2010, the standard deduction amounts are: Single $5,700; Married, fi

Documents

Income Tax Fundamental 2011