Chapter 3

Individual Taxation - An Overview

(Revised11-04-2016)

  • From Income to Taxable Income
Income from whatever source derived {16th Amendment}

-Income Excluded from tax by law

= Gross Income (items shown on return)

Gross Income

-Deductions FOR Adjusted Gross Income

= Adjusted Gross Income (AGI)

-GREATER of: Itemized Deductions or Standard Deduction

= Net before exemptions

-Exemptions ($4,050 each)

= Taxable Income

X Tax Rate

= Tax Liability

-Tax Credits and Prepayments

= Net Tax Due or Refund

Standard Deductions vs. Itemized Deductions

Itemized Deductions(Mainly Personal)

  • Medical expenses over 10% of AGI
  • Taxes: state, local & foreign income & real property taxes, state & local personal property taxes
  • Interest paid: (1st & 2nd) home mortgage interest, usually 100%
  • Contributions: not to exceed 50% of AGI
  • Casualty Losses: over 10% of AGI
  • Miscellaneous: most only over 2% of AGI
  • Itemized Deductions are only deductible on Schedule A, if Form 1040 [long form] is filed.
  • Only claim Itemized deductions if they EXCEEDthe Standard deduction amount.

Overall Limitation on itemized deductions

  • Reduce itemized deductions by 3% of the Amount AGI Exceeds $285,350/$311,300 (Single/MFJ) but not to exceed 80% of Total Itemized deductions.

Standard Deduction (see inside back cover)

BasicAdd if taxpayer or spouse is

Filing StatusAmount“65 or over” or blind [each]

Unmarried $6,300 $1,550

Married Filing Jointly12,6001,250

Head of Household 9,3001,550

Surviving Spouse12,6001,250

Married Filing Separate 6,3001,250

  • If the taxpayers aremarried and fileseparate returns and one of the spouse itemizes, the other spouse must also itemize and may not use the standard deduction

For a Person Claimed as a Dependent on another’s return, the StandardDeduction is: The greater of

$1,050or

$350+ dependent’s earned income;

  • butnot to exceed the normal standard deduction of $6,300 (assuming they are single).

Exemption Deductions

  • $4,050 per allowable exemption in 2016, indexed for inflation (see inside back cover).

The exemption is subject to a phase-out that begins with adjusted gross incomes of $258,250 ($309,900 for married couples filing jointly). It phases out completely at when AGI exceeds the threshold amount by $122,500. See text for details

  • Tax rates depend on the level of the taxpayers’ taxable income, and are 10, 15, 25, 28, 33, 35 and now 39.6%.
  • Tax rates are marginal rates (different rates apply to different portions of your income).

Tax Credits and Prepayments

  • Tax credits reduce tax liability $1 for every one dollar of credit and thus are more valuable than deductions. (See Chapter 9)
  • Tax liability is also reduced by tax withheld from paychecks, estimated tax payments, amounts paid with extension requests, and any other payments.

Net Tax Due or Refund

  • If the total of the credits and payments is more than the liability, the taxpayer can receive the difference as a refund, or credited as a tax payment to the next year.
  • If the total liability is more than the payments and credits, the taxpayer must pay the balance due when the tax return is filed, or negotiate a payment plan with the IRS.

Primary Tax Forms

  • Individuals (Form 1040)
  • Corporations (Form 1120)
  • Fiduciaries (Form 1041)
  • Partnerships (Form 1065)

Exemption Deductions:

Two types of exemptions

  • Personal exemption
  • Dependent exemption

Personal Exemptions

  • Claim for taxpayer(s) only
  • Married filing joint couple gets 2 personal exemptions
  • Each taxpayer gets one personal exemption unless the taxpayercan be claimed as a dependenton another’s return, and if so,they may not claim a personal exemption on their own tax return

Dependency Exemptions

  • One each per Dependent.

Who is a Dependent?

  • “Qualifying Child”
  • “Qualifying Relative“

Qualifying Child

  • Must meet the four tests of the Uniform Definition of a Qualifying Child
  • Principal Abode - must have the same principal place of abode as taxpayer for more than one-half of the taxable year.
  • Relationship - must be the taxpayer’s child (step) or sibling (step) or a descendant of one of those, or legally adopted or placed with the taxpayer.
  • Age - Unless disabled, must be under age 19 (or 24 if a full time student)
  • Support- The childmust not have provided more than one-half of his/her own support during year.

Qualifying Relative

  • A person who meets all of the following four tests:
  1. Relationship or Member of the Household
  2. Gross Income
  3. Support
  4. Is NOT a Qualifying Child

TEST 1: Relationship or member of the household

  • The Dependent meets the relationship test if the dependent is one of the following:
  1. Child of the taxpayer, or
  2. Descendant of the child of the taxpayer, or
  3. Brother, sister, stepbrother or stepsister of the taxpayer
  4. Father, mother or ancestor
  5. Stepfather or stepmother
  6. Son/daughter of brothers/sisters
  7. Brother/sister of father/mother
  8. In-laws: mother, father, sister, brother, son, daughter
  9. Any other person who (legally) lives with you all year

TEST 2: Gross Income Earned By the Dependent

  • Cannot exceed the exemption amount of $4,050 (a “qualifying child” can do so)
  • Only consider taxable income

TEST 3: Support of Dependent

General Rule: Support of a qualifying relative provided by the taxpayer must be more thanone-half of the total support of the Dependent

  • What is Support? The value of lodging, clothing, gifts, recreation, medical and dental care, education, etc., as well as a share of common living expenses (e.g. food). It does not include scholarships and amounts not spent on a Dependent. It does include Social Security benefits received by the Dependent, as well as withdrawn savings of the Dependent.

Special Rules

  • Multiple Support Agreements
  • If 2 or more individuals together provide more than one-half of support, but individually no single person does, than anyone providing more than 10% of support can claim that Dependent if the other 10% people consent.
  • Example: Who Supports Grandma?

Grandchild A 40%

B 45

C 10

Others 5_

Totals 100%

Only A or B may claim Grandma

Divorced parents

  • General rule:
  • The custodial parent gets the dependent deduction (if the parents together provide more than one-halfof the support and custody for more than one-halfof the year).
  • Exception: The custodial parent may waive their right to the exemption, and provide Form 8332 to the non-custodial parent who must attach that waiver Form to their own tax return.

Joint Returns

  • The dependent must not file a JOINT return with anyone else

Birth & Death

  • If the taxpayer or a dependent is alive any portion of the year, they receive the full exemption for the entire year.

Computing the Tax

Taxable Income (TI)

Income Tax(using either the Tax Tables if Taxable Income isless than $100,000 or the Tax Rate Schedules (Taxable Income is $100,000 or more)

+ Additional Taxes ( for example:AlternativeMinimum Tax)

= Tax

- Non-Refundable Credits (e.g. childcare credit)

= Total Income Tax

+Other Taxes (e.g. self-employment tax)

= Total Tax {used in figuring penalties}

-Tax payments & other Refundable credits (e.g. Tax withholding,

excess FICA withheld,estimated tax payments)

= Tax Due (or Refund)

Filing Returns

Filing Status

(1) Single

(2) Married Filing Joint returns & qualifying widow(er) withdependent children

(3) Married Filing Separate

(4) Head of Household

  • Marital status is determined on the last day of the tax year

Head of Household qualifications

  • Unmarried (separated) on last day of year
  • Furnished at least one-half of the cost of maintaining a home that for more thanone-halfof the year is the principalplace of abode for either a qualifying child orany other qualifying relative who qualifies as a dependent, except class (9).
  • Place of abode must be the personal residence of the taxpayer (except for parents).

Marginal “Step Based” Tax Rates (See inside front cover)

  • First tier of TAXABLE income is taxed at:
  • 10%, then the next PORTION of income is taxed at
  • 15%, then
  • 25%, then
  • 28%, then
  • 33%,
  • 35% and finally
  • 39.6%

“Kiddie Tax” - Earnings of a minor under age 18, or if a full-time student, under 24

  • If the dependent is a qualifying minor and hasunearned income that exceedstheir standard deduction (see below), then their "net unearned income" over $2,000 is taxed at the parent’s highest marginal rate (see text).

Filing Requirements

A return is required if Gross Income exceeds the Total Standard Deduction + the Exemption amount(see inside back cover).

  • For Example, if filing as a single taxpayer in 2016, not claimed as dependent on another’s return:

Exemption$4,050

Standard Deduction 6,300

Total$10,350

  • If Gross Income exceeds$10,350 then the taxpayer must file
  • Special Rules for Dependents
  • If a taxpayer can be claimed as a Dependent on another’s return,they must file if:
  • Grossincome is at least $6,300 with nounearned income
  • Grossincome is at least $1,000withunearned income
  • A tax return must be filed if any other taxes (e.g. self-employment tax) are owed

Time to File

  • The 15th day of fourth month following close of tax year, but may be extended6 monthsautomatically (extension of time to file, not to pay!)

Joint Return

  • Spouses do not have to file jointly, they may file separately instead
  • Both spouses are "jointly & severally liable" for tax if filing jointly
  • May not change from a joint to separate returns after the due date of the return

Tax Tables vs. Tax Rate Schedules (See Tax Tables at App. T-1 and inside front cover)

  • Must Use Tax Tables if Taxable Income is less than$100,000
  • Must use Tax Rate Schedules if Taxable income is $100,000 or more

Self Employment (SE)Tax

  • Applies to compensation for services ofNon-employees (Independent Contractors). They donot receive a Form W-2, but they may receive aForm 1099(required if payments are at least $600).
  • Net Self Employment income is:
  • Net income from the business times 92.35%
  • The SE tax is 15.3% of Net Self Employment Income, if net SE Income is over $400, and
  • SE Tax Consists of

12.4% of FICA-Social Security portion

+ 2.9% FICA-Medicare portion

=15.3%

  • Taxpayer is allowed a deduction ofone-half of the SE tax for AGI.
  • The maximum Income subject to the 12.4% Social Security withholdingis capped at $118,500.This is the FICA-Social Security Cap.
  • IF (W-2 wages PLUS Net Self-Employment income ) > FICA-Social Security Cap, than:
  • Net Self-Employment income subject to 12.4% FICA-Social Securityis:
  • (FICA Social Security Cap MINUSW-2 wages)
  • There is no cap on the Medicare portion.
  • A self-employed taxpayer is considered to be both an employee and employer, hence pays “both sides” of the Social Security and Medicare tax: 6.2% + 1.45% times 2 = 15.30% total.

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