Individuals Not Eligible for the Standard Deduction

Chapter 16 Digging Deeper

Contents:

INDIVIDUALS NOT ELIGIBLE FOR THE STANDARD DEDUCTION

1. The following individual taxpayers are ineligible to use the standard deduction and therefore must itemize:1

A married individual filing a separate return where either spouse itemizes deductions.
A nonresident alien.
An individual filing a return for a period of less than 12 months because of a change in annual accounting period.

DEPENDENCY EXEMPTIONS

2. Tiebreaker Rules. The following examples illustrate the application of the tiebreaker rules for claiming a qualified child.

Example:Tim, age 15, lives in the same household with his mother and grandmother. As the parent (see Table 16–4), the mother has priority as to the dependency exemption.

Example:Jennifer, age 17, lives in the same household with her parents during the entire year. If her parents file separate returns, the one with the higher AGI has priority as to the dependency exemption.

Example: Assume the same facts as in the previous example, except that the father moves into an apartment in November (Jennifer remains with her mother). The mother has priority as to the dependency exemption.

Example:Carlos, age 12, lives in the same household with his two aunts. The aunt with the higher AGI has priority as to the dependency exemption.

Resorting to the tiebreaker rules in Table 16–4 is not necessary if the person who would prevail does not claim the exemption. Thus, in the first example above, the mother can allow the grandmother to claim Tim as a dependent by not claiming him on her own return.

DEPENDENCY EXEMPTIONS

3. Support Test: Multiple Support Agreement. Each person who qualifies under the more-than-10 percent rule (except for the person claiming the exemption) must complete Form 2120 (Multiple Support Declaration) waiving the exemption. The person claiming the exemption must attach all Forms 2120 to his or her own return.

Taxpayers should maintain adequate records of expenditures for support in the event a dependency exemption is questioned on audit by the IRS. The maintenance of adequate records is particularly important for exemptions arising from multiple support agreements.

DEPENDENCY EXEMPTIONS

4. Support Test: Noncustodial Parent.The waiver, Form 8332 (Release of Claim to Exemption of Child of Divorced or Separated Parents), can apply to a single year, a number of specified years, or all future years. The noncustodial parent must attach a copy of Form 8332 to his or her return. Under certain conditions, a copy of the divorce decree awarding the dependency exemptions to the noncustodial parent can be substituted for Form 8332.

TAX TABLE METHOD

5. The following taxpayers may not use the Tax Table method:

An individual who files a short period return.
Individuals whose taxable income exceeds the maximum (ceiling) amount in the Tax Table. The2007 Tax Table applies to taxable income below $100,000 for Form 1040.2
An estate or trust.

UNEARNED INCOME OF CHILDREN UNDER AGE 19 TAXED AT PARENTS’ RATE

6. Tax Determination. If a child is subject to the kiddie tax, there are two options for computing the tax on the income. A separate return may be filed for the child, or the parents may elect to report the child’s income on their own return. If a separate return is filed for the child, the tax on net unearned income (referred to as the allocable parental tax) is computed as though the income had been included on the parents’ return. Form 8615 is used to compute the tax. The steps required in this computation are illustrated below.

Example:Olaf and Olga have a child, Hans (age 10). In 2008, Hans received $2,900 of interest income and paid investment-related fees of $200. Olaf and Olga had $70,000 of taxable income, not including their child’s investment income. The parents have no qualified dividends or capital gains. Olaf and Olga do not make the parental election. They file a joint return.

1. Determine Hans’s net unearned income.
Gross income (unearned) / $ 2,900
Less: $900 / (900)
Less: The greater of
• $900 or
• Investment expense ($200) / (900)
Equals: Net unearned income / $1,100
2. Determine allocable parental tax.
Parents’ taxable income / $ 70,000
Plus: Hans’s net unearned income / 1,100
Equals: Revised taxable income / $ 71,100
Tax on revised taxable income / $ 10,463
Less: Tax on parents’ taxable income / (10,188)
Allocable parental tax / $275
3. Determine Hans’s nonparental source tax.
Hans’s AGI / $ 2,900
Less: Standard deduction / (900)
Less: Personal exemption / –0–)
Equals: Taxable income / $ 2,000
Less: Net unearned income / (1,100)
Equals: Nonparental source taxable income / $900
Tax on nonparental source taxable income at
10% /
$ 90
4. Determine Hans’s total tax liability.
Nonparental source tax / $ 90
Allocable parental tax / 275
Total tax / $ 365

FILING REQUIREMENTS

7. This table lists the income levels that require income tax returns to be filed under the general rule and under certain special rules.

Filing Status / 2008
Gross
Income / 2007
Gross
Income
Single
Under 65 and not blind / $ 8,950 / $ 8,750
Under 65 and blind / 8,950 / 8,750
65 or older / 10,300 / 10,050
Married, filing joint return
Both spouses under 65 and
neither blind / 17,900 / 17,500
Both spouses under 65
and one or both spouses blind / 17,900 / 17,500
One spouse 65 or older / 18,950 / 18,550
Both spouses 65 or older / 20,000 / 19,600
Married, filing separate return
All—whether 65 or older or blind / 3,500 / 3,400
Head of household
Under 65 and not blind / 11,500 / 11,250
Under 65 and blind / 11,500 / 11,250
65 or older / 12,850 / 12,550
Qualifying widow(er)
Under 65 and not blind / 14,400 / 14,100
Under 65 and blind / 14,400 / 14,100
65 or older / 15,450 / 15,150

FILING REQUIREMENTS

8. Filing Requirements for Dependents. Computation of the gross income filing requirement for an individual who can be claimed as a dependent on another person’s tax return is subject to more complex rules. Such an individual must file a return if he or she has any of the following:

Earned income only and gross income that is more than the total standard deduction (including any additional standard deduction) that the individual is allowed for the year.
Unearned income only and gross income of more than $900 plus any additional standard deduction that the individual is allowed for the year.
Both earned and unearned income and gross income of more than the larger of $900 or the sum of earned income plus $300 (but limited to the applicable basic standard deduction) plus any additional standard deduction that the individual is allowed for the year.

Thus, the filing requirement for a dependent who has no unearned income is the total of the basic standard deduction plus any additional standard deduction, which includes both the additional deduction for blindness and the deduction for being age 65 or older. For example, the 2008 filing requirement for a single dependent who is under age 65 and not blind is $5,450, the amount of the basic standard deduction for 2008. The filing requirement for a single dependent who has no unearned income and is under age 65 and blind is $6,800 ($5,450 basic standard deduction + $1,350 additional standard deduction).

FILING STATUS

9. Limitations on Married Taxpayers Who File Separately. Although changes in the tax rates and the standard deduction have reduced the marriage penalty, the Code places some limitations on married persons who file separate returns. Some examples of these limitations are listed below.

If either spouse itemizes deductions, the other spouse must also itemize.
The earned income credit and the credit for child and dependent care expenses cannot be claimed.
No deduction is allowed for interest paid on qualified education loans.
Only $1,500 of excess capital losses can be claimed.
In such cases, being single would be preferable to being married and filing separately.

FILING STATUS

10. Heads of Household: A dependent must be either a qualifying child or a qualifying relative who meets the relationship test.3

Example:Dylan is single and maintains a household in which he and his cousin live. Even though the cousin may qualify as a dependent (under the member-of-the-household test), Dylan cannot claim head-of-household filing status. A cousin does not meet the relationship test.

Example:Emma, a widow, maintains a household in which she and her aunt live. If the aunt qualifies as a dependent, Emma may file as head of household. Note that an aunt meets the relationship test.

Head-of-household status may be claimed if the taxpayer maintains a separate home for his or her parent or parents if at least one parent qualifies as a dependent of the taxpayer.4

Example:Rick, an unmarried individual, lives in New York City and maintains a household in Detroit for his dependent parents. Rick may use the head-of-household rates even though his parents do not reside in his New York home.

Head-of-household status is not changed during the year by death of the dependent. As long as the taxpayer provided more than half of the cost of maintaining the household prior to the dependent’s death, head-of-household status is preserved.

ALIMONY AND SEPARATE MAINTENANCE PAYMENTS

11. Post-1984 Agreements and Decrees. Payments made under post-1984 agreements and decrees are classified as alimony only if the following conditions are satisfied:

The payments are in cash.
The agreement or decree does not specify that the payments are not alimony.
The payor and payee are not members of the same household at the time the payments are made.
There is no liability to make the payments for any period after the death of the payee.5

Requirement 1 simplifies the law by clearly distinguishing alimony from a property division; that is, if the payment is not in cash, it must be a property division. Requirement 2 allows the parties to determine by agreement whether or not the payments will be alimony. The prohibition on cohabitation—requirement 3—is aimed at assuring that the alimony payments are associated with duplicative living expenses (maintaining two households).6 Requirement 4 is an attempt to prevent alimony treatment from being applied to what is, in fact, a payment for property rather than a support obligation. That is, a seller’s estate generally will receive payments for property due after the seller’s death. Such payments after the death of the payee could not be for the payee’s support.

Front-Loading. As a further safeguard against a property settlement being disguised as alimony, special rules apply to post-1986 agreements if payments in the first or second year exceed $15,000. If the change in the amount of the payments exceeds statutory limits, alimony recapture results to the extent of the excess alimony payments. In the third year, the payor must include the excess alimony payments for the first and second years in gross income, and the payee is allowed a deduction for these excess alimony payments. These complex alimony recapture provisions are covered in § 71(f) of the Code.

SOCIAL SECURITY BENEFITS

12. If a taxpayer’s income exceeds a specified base amount, as much as 85 percent of Social Security retirement benefits must be included in gross income. The taxable amount of benefits is determined through the application of one of two formulas that utilize a unique measure of income—modified adjusted gross income (MAGI).7 MAGI is, generally, the taxpayer’s adjusted gross income from all sources (other than Social Security) plus the foreign earned income exclusion and any tax-exempt interest income.

In the formulas, two sets of base amounts are established. The first set is as follows:

$32,000 for married taxpayers who file a joint return.
$0 for married taxpayers who do not live apart for the entire year but file separate returns.
$25,000 for all other taxpayers.

The second set of base amounts is as follows:

$44,000 for married taxpayers who file a joint return.
$0 for married taxpayers who do not live apart for the entire year but file separate returns.
$34,000 for all other taxpayers.

If MAGI plus one-half of Social Security benefits exceeds the first set of base amounts, but not the second set, the taxable amount of Social Security benefits is the lesser of the following:

.50(Social Security benefits).
.50[MAGI + .50(Social Security benefits) - first base amount].

Example:A married couple with adjusted gross income of $30,000, no tax-exempt interest, and $11,000 of Social Security benefits who file jointly must include $1,750 of the benefits in gross income. This works out as the lesser of the following:

.50($11,000) = $5,500.
.50[$30,000 + .50($11,000) - $32,000] = .50($3,500) = $1,750.

If instead the couple had adjusted gross income of $15,000 and their Social Security benefits totaled $5,000, none of the benefits would be taxable, since .50[$15,000 + .50($5,000) - $32,000] is not a positive number.

If MAGI plus one-half of Social Security benefits exceeds the second set of base amounts, the taxable amount of Social Security benefits is the lesser of 1 or 2 below:

.85(Social Security benefits).
Sum of:
.85[MAGI + .50(Social Security benefits) - second base amount], and
Lesser of:
Amount included through application of the first formula.
$4,500 ($6,000 for married filing jointly).

Example:A married couple who file jointly have adjusted gross income of $72,000, no tax-exempt interest, and $12,000 of Social Security benefits. Their includible Social Security benefits will be $10,200.

Include the lesser of the following:

.85($12,000) = $10,200.
Sum of:
.85[$72,000 + .50($12,000) - $44,000] = $28,900, and
Lesser of:
Amount calculated by the first formula, which is the lesser of:
.50($12,000) = $6,000.
.50[$72,000 + .50($12,000) - $32,000] = $23,000.
$6,000.

The sum equals $34,900 ($28,900 + $6,000). Since 85% of the Social Security benefits received is less than this amount, $10,200 is included in the couple’s gross income.

GIFTS AND INHERITANCES

13. In a landmark case, Comm. v. Duberstein,8 the taxpayer (Duberstein) received a Cadillac from a business acquaintance in appreciation for numerous customers Duberstein had referred to the acquaintance. Duberstein had supplied the businessman with the names of potential customers with no expectation of compensation. The Supreme Court concluded:

. . . despite the characterization of the transfer of the Cadillac by the parties [as a gift] and the absence of any obligation, even of a moral nature, to make it, it was at the bottom a recompense for Duberstein’s past service, or an inducement for him to be of further service in the future.

Duberstein was therefore required to include the fair market value of the automobile in gross income.

MEDICAL EXPENSES

14. Transportation and Lodging. A deduction is also allowed for the transportation expenses of a parent who must accompany a child who is receiving medical care or for a nurse or other person giving assistance to a person who is traveling to get medical care and cannot travel alone.

The deduction for lodging expenses included as medical expenses cannot exceed $50 per night for each person. The deduction is allowed not only for the patient but also for a person who must travel with the patient (e.g., a parent traveling with a child who is receiving medical care).

INTEREST

15. Investment Interest. When investment expenses fall into the category of miscellaneous itemized deductions that are subject to the 2 percent-of-AGI floor, some of the expenses may not enter into the calculation of net investment income because of the floor.

Example:Gina has AGI of $80,000, which includes qualified dividends of $15,000 and interest income of $3,000. Besides investment interest expense, she paid $3,000 of city ad valorem property tax on stocks and bonds and had the following miscellaneous itemized expenses:

Safe deposit box rental (to hold investment securities) / $ 120
Investment counsel fee / 1,200
Unreimbursed business travel / 850
Uniforms / 600
Total miscellaneous itemized deductions / $2,770

Before Gina can determine her investment expenses for purposes of calculating net investment income, those miscellaneous expenses that are not investment expenses are disallowed before any investment expenses are disallowed under the 2%-of-AGI floor. This is accomplished by selecting the lesser of the following:

The amount of investment expenses included in the total of miscellaneous itemized deductions subject to the 2%-of-AGI floor.
The amount of miscellaneous expenses deductible after the 2%-of-AGI rule is applied.

The amount under item 1 is $1,320 [$120 (safe deposit box rental) + $1,200 (investment counsel fee)]. The item 2 amount is $1,170 [$2,770 (total of miscellaneous expenses) - $1,600 (2% of $80,000 AGI)].

Then, Gina’s investment expenses are calculated as follows:

Deductible miscellaneous deductions investment expense
(the lesser of item 1 or item 2) / $1,170
Plus: Ad valorem tax on investment property / 3,000
Total investment expenses / $4,170

Gin elects to include the qualified dividends in investment income. Gina’s net investment income is $13,830 ($18,000 investment income - $4,170 investment expenses).

After net investment income is determined, deductible investment interest expense can be calculated. Disallowed investment interest may be carried over to future years. No limit is placed on the length of the carryover period. The investment interest expense deduction is determined by completing Form 4952.

Example:Adam is an attorney employed by a law firm. His investment activities for the year are as follows:

Net investment income / $30,000
Investment interest expense / 44,000

Adam’s investment interest deduction is $30,000. The $14,000 of investment interest disallowed ($44,000 investment interest expense - $30,000 allowed) is carried over to future years.

CHARITABLE CONTRIBUTIONS

16. Record-Keeping Requirements.For a number of years, taxpayers contributing $250 or more have been required to obtain a written acknowledgment from the charity to secure the deduction. But beginning in 2007, cash contributions of less than $250 must be supported by a bank record (e.g., a canceled check) or written documentation from the charity. This rule applies to any contribution, regardless of how small it may be.A charitable contribution of noncash property worth $250 or more also must be properly substantiated. The substantiation must specify the description of the property contributed and it must be obtained before the earlier of (1) the due date (including extensions) of the return for the year the contribution is claimed or (2) the date such return is filed.