Chapter 07
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Chapter 07. Individual Income Tax Computation and Tax Credits. Learning Objectives. Determine a taxpayer’s regular tax liability and identify tax issues associated with the process.

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Chapter 07

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Chapter 07

Chapter 07

Individual Income Tax Computation and Tax Credits

Learning objectives

Learning Objectives

  • Determine a taxpayer’s regular tax liability and identify tax issues associated with the process.

  • Compute a taxpayer’s alternative minimum tax liability and describe the tax characteristics of taxpayers most likely to owe the alternative minimum tax.

  • Calculate a taxpayer’s employment and self-employment taxes payable and explain tax considerations relating to whether a taxpayer is considered to be an employee or a self-employed independent contractor.

Learning objectives cont d

Learning Objectives (cont’d)

  • Describe the different general types of tax credits, identify specific tax credits, and compute a taxpayer’s allowable child tax credit, child and dependent care credit, earned income credit, American opportunity credit, lifetime learning credit, and earned income credit.

  • Explain taxpayer filing and tax payment requirements and describe in general terms how to compute a taxpayer’s underpayment, late filing, and late payment penalties.

Federal income tax computation

Federal Income Tax Computation

  • Regular tax computation dependent upon:

    • Filing status

      • Married filing jointly

      • Qualifying widow or widower (also called Surviving spouse)

      • Married filing separately

      • Head of household

      • Single

    • Progressive tax rates

      • Tax rate schedules

      • Tax tables

Federal income tax computation1

Federal Income Tax Computation

  • Tax brackets or marginal tax rates on ordinary income

    • 10%, 15%, 25%, 28%, 33%, and 35%

  • Marriage penalty or benefit

    • Who is likely to have penalty?

      • Both spouses receive income

    • Who is likely to have benefit?

      • One spouse receives income

Federal income tax computation2

Federal Income Tax Computation

  • Exceptions to ordinary tax rates

    • Long-term capital gains (net capital gains)

      • Generally 15% but can be as high as 28% or as low as 0%

      • Two different tax rates on one gain is possible

    • Dividends

      • Qualified dividends generally taxed at 15% but could be taxed as low as 0%.

      • Two different tax rates on one dividend is possible

Tax computation example

Tax Computation Example

Assume that Gram’s taxable income is $35,000 including $4,000 of qualifying dividends taxed

at the preferential rate. What would be Gram’s tax liability on her income under these circumstances?

Tax computation example solution

Tax Computation Example Solution

Federal income tax computation3

Federal Income Tax Computation

  • Kiddie tax

    • Net unearned income taxed at parents’ marginal rate

      • Net unearned income = unearned income in excess of $1,900

      • Parents can elect to actually include this income on their tax return.

    • Applies if

      • Child is under age 18 at year end,

      • Child is 18 at year end but earned income not greater than half of child’s support, or

      • Child is over age 18 but under age 24, is a full-time student, and child’s earned income not greater than half of child’s support.

Kiddie tax example

Kiddie Tax Example

Suppose that during 2011, Deron received $1,000 in interest from an IBM bond, and he received another $2,100 in interest income from a money market account that his parents have been contributing to over the years. What is Deron’s taxable income and corresponding tax liability? (Deron’s mother Courtney is subject to a 25% marginal tax rate.)

Kiddie tax example solution

Kiddie Tax Example Solution

Because Deron is younger than 18 years of age at the end of the year and his net unearned income exceeds $1,900, he is potentially subject to the kiddie tax.

Kiddie tax example solution cont d

Kiddie Tax Example Solution (cont’d)

Alternative minimum tax formula

Alternative Minimum Tax Formula

Alternative minimum tax

Alternative Minimum Tax

  • Items commonly added back to regular taxable income in computing AMT income

    • Personal and dependency exemptions

    • State income taxes

    • Real property taxes

    • Home-equity loan interest expense (if proceeds not used to improve home)

    • Miscellaneous itemized deductions in excess of 2% floor

Alternative minimum tax1

Alternative Minimum Tax

  • Exemption phased out 25 cents for each dollar over threshold

Alternative minimum tax2

Alternative Minimum Tax

  • AMT is a tax based on an alternative more inclusivetax base than regular taxable income.

    • Meant to ensure that taxpayers are paying some minimum level of tax.

  • Who is most likely to pay it and why?

    • High state taxes

    • Multiple children

    • Capital gains

Alternative minimum tax3

Alternative Minimum Tax

  • Why is it becoming so prevalent?

    • Exemption amount and phase-out threshold not indexed for inflation

    • Individual tax rates have been decreasing.

  • AMT rates 26% or 28% vs. individual ordinary rates 10%, 15%, 25%, 28%, 33%, 35%

Employment and self employment taxes

Employment and Self-Employment Taxes

  • FICA taxes consist of two components:

    • Social Security tax – 12.4% (10.4% in 2011)

      • Wage base limited to $106,800 in 2011

    • Medicare tax – 2.9%

      • No wage base limitation

Employment fica taxes

Employment FICA Taxes

  • Employee

    • Must pay FICA taxes on compensation from employer (4.2 % Social Security tax rate; 1.45% Medicare tax rate)

    • Multiple employers during year

  • Employer

    • Pays FICA tax on employee’s compensation (6.2% Social Security tax rate; 1.45% Medicare tax rate)

    • & withholds FICA tax from employee’s pay check

Employment and self employment taxes1

Employment and Self-Employment Taxes

  • Self-employed taxpayers

    • Responsible for entire FICA tax (employee and employer share)

  • Steps to computing SE tax

    • Compute net Schedule C income (generally) and multiply by .9235

      • This equals net earnings from self-employment

    • Determine Social Security tax 10.4% and Medicare tax 2.9%

      • $106,800 limit applies to Social Security portion

Employment and self employment taxes2

Employment and Self-Employment Taxes

  • If net earnings from self-employment < $400, no SE tax.

  • How does $106,800 Social Security earnings limit apply when have both wages and SE earnings in the same year?

    • Wages use up limit first– taxpayer favorable or unfavorable? Why?

Employment and self employment taxes example

Employment and Self-Employment Taxes Example

Assume that Courtney received $100,000 of taxable compensation from EWD in 2011, and she received $18,000 in self-employment income from her weekend consulting activities. What amount of self-employment taxes is Courtney required to pay on her $18,000 of business income?

Employment and self employment taxes example solution

Employment and Self-Employment Taxes Example Solution

Employee vs independent contractor

Employee vs. Independent Contractor

  • Determining whether taxpayer is employee or independent contractor

    • Primary question: who has control over how, when, where work is performed?

  • Tax differences

    • Amount of FICA or SE taxes payable

    • Deductibility of expenses

      • For AGI

      • From AGI

      • One-half of self-employment taxes

Tax credits

Tax Credits

  • Reduce tax liability dollar for dollar

  • Consist of three categories

    • Nonrefundable personal

    • Refundable personal

    • Business

Nonrefundable personal

Nonrefundable Personal

  • Child tax credit

    • $1,000 for each qualifying child under age 17 at end of year

      • Partially refundable in certain situations

    • Phase-out amount not percentage

  • Child and Dependent care credit

    • Dependent under age of 13 (or disabled dependent)

    • Percentage of qualifying expenditures

      • Maximum qualifying expenditures: $3,000 one qualifying person, $6,000 two or more qualifying persons

    • Percentage depends on AGI (see Exhibit 7-9)

Nonrefundable personal1

Nonrefundable Personal

Nonrefundable personal2

Nonrefundable Personal

  • American opportunity credit (formerly Hope scholarship credit)

    • For first four years of post-secondary education

    • For eligible expenses and institutions only

    • Applied per student

      • Taxpayer, spouse, taxpayer’s dependents

      • Amounts paid by dependents treated as paid by taxpayer

    • 100% of first $2,000 of eligible expenses and 25% of next $2,000 (maximum credit is $2,500)

    • Phase-out based on AGI

    • 40% of credit is refundable

American opportunity credit example

American Opportunity Credit Example

Courtney paid $2,000 of tuition and $300 for books for Ellen to attend the University of Missouri–Kansas City during the summer at the end of her freshman year. What is the maximum American opportunity credit (before phase-out) Courtney may claim for these expenses?

American opportunity credit example solution

American Opportunity Credit Example Solution

Answer: $2,075.

Because the cost of tuition and books are eligible expenses, Courtney may claim a maximum American opportunity credit before phase-out of $2,075 [($2,000 × 100%) + ($2,300 - $2,000) × 25%].

American opportunity credit example1

American Opportunity Credit Example

Assuming Courtney qualifies for a $2,075 American opportunity credit, she is married filing jointly, and her AGI is $162,000, what amount of American opportunity credit would she be allowed to claim after phase-out?

American opportunity credit example solution1

American Opportunity Credit Example Solution

Nonrefundable personal3

Nonrefundable Personal

  • Lifetime learning credit

    • Eligible expenses (tuition) for post-secondary education

      • Includes professional or graduate school

      • Includes continuing education

    • Applied per taxpayer

      • MFJ return is one taxpayer

    • 20% of up to $10,000 of eligible expenses

    • Phase-out based on AGI

Nonrefundable personal4

Nonrefundable Personal

  • Education credits

    • If deduct for AGI educational expenses for someone, no education credit allowed for that person

      • Could take American opportunity credit for one dependent and for AGI deduction for another

Refundable personal

Refundable Personal

  • Earned income credit

    • Negative income tax

    • Must have earned income

    • Must have at least one qualifying child or must be at least 25 years old and less than 65 and not a dependent of another

    • See Exhibit 7-10

Refundable personal1

Refundable Personal

Tax credits1

Tax Credits

  • Business credits

    • Promote certain behaviors

    • If credit exceeds tax, carry back one year and carry forward 20 years

    • Foreign tax credit

      • Hybrid business and personal – nonrefundable; carry back one year and carry forward 10 years

Tax credits2

Tax Credits

Prepayments and filing requirements

Prepayments and Filing Requirements

  • Taxes must be paid-as-you-go

    • Withholdings

      • Treated as made equally throughout the year

    • Estimated tax payments

      • Due on April 15th,, June 15th, September 15th, and January 15th of the following year

Prepayments and filing requirements1

Prepayments and Filing Requirements

  • Underpayment penalties

    • Safe-harbor requirements

      • 90% of current tax liability or

      • 100% of previous year’s tax liability (110% with higher AGI > $150,000) – 25% at each estimated filing deadline

Prepayments and filing requirements2

Prepayments and Filing Requirements

  • Underpayment penalties

    • Applied on quarterly basis

      • 90%/4 = 22.5% of current year liability must be paid in by deadline or

      • 100%/4 = 25% of previous year’s liability must be paid in by deadline

    • Penalty based on amount of underpayment at each quarter x federal short term rate + 3%

Prepayments and filing requirements3

Prepayments and Filing Requirements

  • Filing requirements

    • Generally, must file if gross income > standard deduction + personal exemption amounts

    • If married filing separately must file if gross income > personal exemption amount

    • Lower thresholds for those claimed as dependent on another’s tax return

Prepayments and filing requirements4

Prepayments and Filing Requirements

  • Due dates

    • April 15th

    • Extend filing up to six months

      • May not extend due date for paying taxes

Prepayments and filing requirements5

Prepayments and Filing Requirements

  • Late filing penalty

    • 5% of tax owed per month up to 25% if not fraudulent; 15% of tax owed per month up to 75% if fraudulent

    • No penalty if no tax is due

  • Late payment penalty

    • If don’t pay entire tax owed by due date of return

      • .5% of amount due up to 25% maximum if not fraudulent

      • 15% of amount due per month up to 75% if fraudulent

  • Combined late filing and late payment penalties may not exceed maximum amounts for either one

Late filing and late payment penalty example

Late Filing and Late Payment Penalty Example

Assume Courtney filed her tax return on April 10 and included a check with the return for $2,918 made payable to the United States Treasury. The $2,918 consisted of her underpaid tax liability of $2,892 and her $26 underpayment penalty. If Courtney had waited until May 1 to file her return and pay her taxes, what late filing and late payment penalties would she owe?

Late filing and late payment penalty example solution

Late Filing and Late Payment Penalty Example Solution

Answer: Her combined late filing penalty and late payment penalty would be $145 ($2,892 late payment × 5 percent × 1 month or portion thereof). Note that the combined late filing and late payment penalty is limited to 5 percent per month.

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