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Chapter 14 The Individual Tax Model Filing Status - Married If married on the last day of the year: status must be either Married filing joint or Married filing separately. MFJ rates apply to Surviving Spouse widow or widower with a dependent child for two more years after death of spouse.

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Chapter

14

The Individual Tax Model


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Filing Status - Married

  • If married on the last day of the year: status must be either Married filing joint or Married filing separately.

  • MFJ rates apply to Surviving Spouse

    • widow or widower with a dependent child for two more years after death of spouse.

  • MFS (married filing separately) rates are less favorable than single.

    • Generally only used for separated couples or US citizens or residents married to a nonresident alien


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Filing Status - Unmarried

  • Single is the default category for unmarried individuals (neither surviving spouse nor head of household).

  • Head of household - maintain a home for either

    • child (need not be dependent)

    • dependent relative


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Taxable Income Computation

  • Calculate total income totaling Line 22 on 1040.

  • Calculate Adjusted Gross Income (AGI) on Line 37 of 1040.

  • Subtract the greater of:

    • itemized deductions or

    • the standard deduction

  • Subtract total exemptions

  • Result is Taxable Income


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Individual Tax Model – Gross Income / Exclusions

  • General Rule: Gross Income is “Broadly Conceived”: Includes all income subject to taxation unless specifically indicated as not taxable by law.

  • Exclusions include:

    • unrealized gains, gifts, inheritances, welfare type payments, many fringe benefits, returns of capital, Municipal Interest, some US Govt for higher education, life insurance proceeds.

  • Scholarships - excludible if

    • recipient is candidate for degree, amount received is not a payment for services, and is used to pay tuition, books, and other similar educational expenses

  • Foreign earned Income (Sec. 911) - build U.S. Economy

    • Exclude up to $87,600 of foreign earned income annually plus a housing allowance (exclusion cannot exceed earned income

    • Individual must be a bona fide resident of the foreign country for an entire tax year or be in the foreign country for 11 mos in any 12 month period.


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Individual Tax Model: Special Income Inclusions

  • Annuities: Amount not taxed: Inv. / Expected Return * Pymts Rec

  • Deferred Compensation Plans: Defined Contribution Plans, Defined Benefit Plans - Qualified Retirement Plans

  • Prizes and Awards - include FMV

  • Social Security Benefits - up 85% may be taxed

  • Unemployment compensation is taxable

  • Alimony received is taxable / Child support is not includible but is not deductible either.


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Special Rules

  • Dividends (cash and noncash) - FMV of prop received (subject to E& P provisions)

  • Stock dividends generally not taxable

  • Damages - personal (special rules) business damages not excludible.

  • Discharge of indebtedness - generally includible.


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Business versus Investment

  • Business activity

    • Time and talent on regular basis

    • Profit partially attributable to personal involvement

    • Income is considered earned income

    • Hobby losses only deductible to extent of hobby income – not a business activity

  • Investment activity

    • Passive role as owner of income-producing property

    • Income is considered unearned income

    • Losses on personal use assets are not deductible – gains from sale are treated as capital assets.


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Investments in Financial Assets

  • Securities include:

    • common and preferred stock

    • savings accounts, CDs, notes, bonds

  • Return on / Income from investment includes

    • Interest (ordinary income)

    • Dividends (special rules post May 2003)

      • Reinvested dividends are still taxable but increase basis.

    • gains (losses).

      • Mutual funds may report ‘distributed’ capital gains/losses. These are still taxable but increase basis even if no cash received.


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Gains/Losses on Securities

  • Realization requires a sale or exchange

  • Gain/loss = Proceeds = adjusted basis

  • Character is capital - time period matters

  • Basis issues

    • reinvested dividends increase basis.

    • Sale of stock uses either specific ID or FIFO method of matching basis with sales.

    • Mutual fund shares sold typically use an average basis.


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What to do with Capital Gains and Losses

  • SHORT TERM asset held for <= 1 year – gains taxed as ordinary income

  • LONG TERM asset held for > 1 year

    • L/T Gains taxed at lower capital gains tax rate of 15%

  • Net the gains and losses in each class (net ST, net LT, net 28%LT).

  • Special rule for sale of principal residence

    • Exclude gain on sale if home is principal residence 2 years out of 5 years ending on date of sale.

    • Exclude only one gain every 2 years.

    • Limits $500,000 MFJ, $250,000 other


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Deductions for Adjusted Gross Income and AGI

  • Deductions for Adjusted Gross Income

    • Trade/Business Exp from a Sole Proprietorship are reported on Schedule C / or for a rental property are recorded on schedule E

    • Student Loan interest up to $2500 (Income limits apply)

    • Self Employed Expenses: 50% of SE tax, percentage of health insurance premiums, Keogh and Simple retirement plans

    • IRAs, Moving Expenses, Contributions to MSAs

    • Penalty for early withdrawal of savings

  • Result of Income less deductions for Adjusted Gross Income –is AGI (very key concept) - many deductions are a function of AGI (e.g., IRA deductions, medical expenses, charitable contributions)

    • Many items of gross income are also a function of AGI

      • Social Security Benefits, Passive Activity Losses


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Deductions from AGI: Standard Deduction or Itemized Deductions

  • Standard Deduction Depends on filing status. For 2008/2009:

    • MFJ = $10,900/$11,400

    • MFS = $5,450 / 5,700

    • HOH = $8,000 / 8,350

    • Single = $5,450 / 5,700

  • Blind or aged (>=age 65)

    • MJF, MFS = additional $1,050/$1,100

    • HOH or Single = additional $1,350/$1,400

  • Take the higher of Standard Deduction or Itemized Deductions as a reduction of AGI in the computation of Taxable Income – Discussion of Itemized Deductions follows


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Itemized Deductions / Personal Losses - Chapter 17 Deductions

  • Itemized deductions

    • a special class of deductions that allow taxpayers to derive tax benefits from certain personal & investment expenditures

  • Individuals deduct the greater of the standard deduction for his/her filing status or the total of his/her itemized deductions.

  • About 1/3 of all TPs claim itemized deductions

  • Itemized deductions are shown on Form 1040 Schedule A.


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Medical Expense Deduction Deductions

  • Sec. 213 - qualified non-reimbursed medical expenses for a TP and dependents qualify for a deduction subject to a 7.5% of AGI floor. (only 5% of TPs benefit)

  • Qualifying expenses include

    • Medical insurance premiums / prescription drugs

    • Medical treatment / Physical & Psychological treatment

    • medical products, glasses, artificial limbs etc.

    • Capital improvements - limited to excess over increase in home value due to the improvements.

    • Capital improvements to remove structural barriers for physically handicapped - fully deductible.

    • Cosmetic surgery if it results from disease, personal injury or congenital defects.

  • No deduction allowed for:

    • Elective cosmetic surgery


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Taxes Deductions

  • Sec 164 - lists deductible taxes

  • In general - only income taxes (other than Federal) and property taxes -ad valorem taxes on investment and personal property are deductible.

  • Taxes must be distinguished from assessments, fines & penalties which are not deductible.

  • Taxes are only deductible when they are the taxpayers obligations. No deduction for paying another persons taxes. No deduction is someone else pays your taxes.

  • 50% of SE tax is deductible,

  • Sales tax are not deductible if total is greater than income taxes paid to a particular state.


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Interest Deductions

  • Sec 163 - certain types of interest paid or accrued by a taxpayer during the year is deductible

    • Mortgage interest, some points, home equity interest or investment interest - are individual itemized deductions

  • Investment interest expense- deductible to extent of net investment income ( Gross Inv. Inc - Inv. Exp.)

    • Inv. Interest deduction not allowed if used to purchase tax exempt securities.

  • Qualified Residence Interest

    • indebtedness used to purchase, construct or improve the taxpayers residence

    • 2 homes allowed -Int on debt up to $1 Million is ded..

    • Home equity interest limited to principal of 100K

    • Point on new loan or improvement loan deductible when paid. Refinancing - amortized over loan life.


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Charitable Contributions Deductions

  • Sec 170 - gifts to qualified charities is deductible

  • Qualified charities: U.S. based organizations operated exclusively for religious, charitable, scientific, literary or educational purposes or for the prevention of cruelty to children or animals.

  • Contribution amount

    • reduced by value of any benefit received by the donor

    • LTCG property = value is FMV

    • No deduction allowed for contribution of services or rent free use of property.

  • Contribution Limits

    • LTCG property - limited to 30% of AGI

    • Total contributions limited to 50% of AGI

    • Excess contributions can be carried forward 5 years

  • If contributing property, TP must be able to substantiate value.

    • Must file form 8283 if noncash contributions > 500

    • Independent appraisal is required when a single item of donated property is valued in excess of $5,000.


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Casualty Losses / Miscellaneous Itemized Deductions Deductions

  • Casualty losses - unreimbursed losses due to theft or casualty. Losses are reduced by $100 and 10% of AGI. Excess, if any is deductible as an itemized deduction.

  • Misc. deductions subject to 2% of AGI limitation- (must exceed 2% of AGI to be deductible)

    • Unreimbursed Employee Business Expenses - union dues, uniforms, business use of auto, job search, other prof. Dues

    • Expenses for managing or safeguarding assets: safe deposit rental, investment advice, investment publications

    • Tax determination expenses: Tax prep fees, legal representation in tax audit, legal and accounting fees for tax planning, appraisals for tax reporting

  • Misc. deductions not subject to 2% limitation

    • gambling losses to extent of gambling winnings

    • unrecovered investments in annuities due to annuitants death.


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Exemptions Deductions

  • Personal exemption for the taxpayer (2 for MFJ).

    • If you are a dependent on someone else’s return, can you still claim yourself?

  • Exemption = $3,500/$3,650 in 2008/2009 for each personal or dependency exemption.


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Exemptions for Dependents Deductions

  • Family member OR live in your home for entire year.

  • You provide > 1/2 financial support

  • Dependent’s gross income < exemption amount ($3,500-08 or $3,650 for 09)

    • waived for child < 19 OR student-child<24

  • Dependent may not generally file a joint return.

  • Dependent must be a U.S. citizen OR a resident of US, Mex, Canada


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Rich People Deductions

  • Phase-out of itemized deductions - If AGI greater than $159,950 (MFJ) in 2008 or $166,800 (MFJ) in 2009, itemized deductions are reduced by (1% of AGI > Threshold ). Can’t reduce itemized deductions below 20% of the total.

  • Phase-out of exemptions - IF AGI greater than $239,950 (MFJ) in 2008 or $250,200 in 2009, reduce exemption by 2% for each $2500 that AGI is above the threshold. Can reduce to $2,433 (TY 09) or $2,333 (TY 08) per exemption. General Rule if AGI > $365,000 only $2,333 or $2,433 per qualifying person allowed for tax years 2008 and 2009, respectively.

  • See appendices at back of chapter for computations. Phaseouts scheduled to be eliminated gradually starting 2006 to 2009


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Tax Credits Deductions

  • A credit is a dollar for dollar reduction in the tax liability. A deduction only reduces the tax by the marginal tax rate associated with that deduction.

  • Child Credit = $1,000 per child in 2007/8. Phases out for rich.

  • Dependent care credit (child < 13 years old). Credit amount between 30% and 20% of child care costs depending on income range.

  • Earned income credit. This is refundable - a transfer payment to working poor. Increases progressivity of tax rates. Credit is higher for taxpayers with children and phases out as income increases.

  • Excess FICA withholding is refunded through a tax return claim.


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Tax Subsidies for Education Deductions

  • Hope scholarship credit - 1st 2 years of college. Max $1500 per year per student based on tuition/fees.

  • Lifetime learning credit = 20% of tuition/fees: Max $5000 per year.

  • Hope and Lifetime phase out begins $80,000 MFJ

  • Education IRA - withdrawals spend on education are tax-free.


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Payment and Filing Requirements Deductions

  • Taxes on wages are withheld each pay period.

  • Estimated taxes are due on April 15, June 15, September 15, and January 15.

  • Pay 90% of current year tax, 100% of prior year (or 110% of prior year AGI>$150,000).

  • Tax return due 4/15, but may be extended to 10/15 (LAST DATE).


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Kiddie Tax Deductions

  • Children under age 18 with unearned income greater than $1,800 are subject to kiddie tax

  • The unearned income in excess of $1,800 is taxed at the parent’s highest marginal tax rate

  • The residual taxable income is taxed at the child’s rate.

  • What are the kiddie tax provisions designed to prevent?


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Wealth Transfer Tax System – Covered on last day of class. Deductions

  • This is an excise tax system which is different from the income tax system.

  • Gift, estate, and generation skipping transfer taxes

  • The unified gift and estate tax is based on cumulative transfers over time (life + death).

  • Graduated rates up to 50%

  • In 2001, Congress repealed the estate and generation-skipping taxes effective in 2010


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Gift Tax Deductions

  • Remember, all receipts of gifts are excluded from INCOME taxation. We are now discussing GIFT taxation.

  • Exclude $12,000 per year per donee from taxable gifts.

  • No gift tax on gifts to spouse, charity, paying tuition or medical costs.

  • Can treat gift by one spouse as made 1/2 by other spouse.


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Exclusion Deductions

  • Lifetime exclusion

  • 2006 $2,000,000

  • 2009 $3,500,000


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Income Tax Effects of Gifts Deductions

  • Gift is not taxable income to donee.

  • Donor’s adjusted basis in the property carries over to become the donor’s basis.

    • exception - use FMV if less than adjusted basis

  • After gift, any income derived from the property belongs to the donee.


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Estate Tax Deductions

  • Taxed at unified estate and gift rate schedule

  • FMV of estate is taxed

  • Unlimited marital deduction

  • Reduce estate by taxes, charity, administrative expenses.


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Income Tax Effect of Bequests Deductions

  • Receipt of a bequest is not taxable income to heir.

  • Basis = FMV at date of death = free income tax step-up in basis. (In 2010, wealthy estates generate carryover basis).

  • Trade-off -

    • gift now at low basis, perhaps avoid some transfer tax

    • keep and include in estate, but heirs get high basis


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