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Income Taxation of Individuals. Chapter 11. Individual Income Tax Model. Gross income Less: Deductions for adjusted gross income Equals: Adjusted Gross Income (AGI) Less: Itemized or standard deduction Less: Personal & dependency exemptions Equals: Taxable income.

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Income Taxation of Individuals

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individual income tax model
Individual Income Tax Model

Gross income

Less: Deductions for adjusted gross income

Equals:Adjusted Gross Income (AGI)

Less: Itemized or standard deduction

Less: Personal & dependency exemptions

Equals: Taxable income

tax model continued
Tax Model (continued)

Taxable income

Times: Tax rate

Equals: Gross income tax liability

Less: Tax credits

Plus: Additions to tax

Less: Tax prepayments

Equals: Net tax due or tax refund

deductions for agi
Deductions For AGI
  • Deductions discussed in previous chapters
    • Retirement plan contributions including IRAs
    • Moving expenses
    • 50% of self-employment taxes
    • Self-employed health insurance
    • Alimony paid
deductions for agi5
Deductions For AGI
  • Deductions discussed in this chapter
    • Educator expenses
    • Student loan interest expense
    • Tuition and fees deduction
    • Penalty on early withdrawals of savings
    • Health savings accounts
    • National guard & military reserve travel
educator expenses
Educator Expenses
  • Kindergarten through 12th grade teachers may deduct up to $250 of unreimbursed expenses for books, supplies, computer equipment, software, and other supplemental materials used in the classroom
    • Expired at end of 2003 but expected to be extended retroactively by Congress
student loan interest
Student Loan Interest
  • Deduction allowed for interest paid on qualified student loans incurred and used for tuition, fees, room, board, books, and supplies
  • Deduction limit is $2,500
    • Limit is phased out for modified AGI of $50,000 - $65,000 ($100,000 - $130,000 for married persons filing jointly)
    • Individuals claimed as dependents cannot take deduction on their own tax return
    • Expenses paid by tax-exempt scholarships or subject to education credits must be excluded from loan amounts and related interest
tuition fees deduction
Tuition & Fees Deduction
  • $4,000 deduction for 2004-2005 for tuition & fees for taxpayer, spouse, and dependents
    • Income limits apply ($65,000 if single and $130,000 if married filing jointly)
  • Deduction is reduced to $2,000 for singles with income $65,000 - $80,000 ($130,000 - $160,000 for joint filers)
    • Individuals who are claimed as dependents cannot take deduction on their own tax return
    • No double benefit - no deduction if expense is deductible under any other provision (including education credits)
penalty on early withdrawals
Penalty on Early Withdrawals
  • Penalties assessed on premature withdrawals from certificates of deposits or other savings accounts are deductible
    • Gross interest income, unreduced by the penalty, is included in taxable income
    • Deducting the penalty ensures that only net interest income is included in taxable income
health savings accounts
Health Savings Accounts
  • Taxpayers covered by high-deductible medical insurance policies only may deduct amounts set aside in an MSA or HSA
  • Contributions and earnings on MSAs and HSAs are not taxed when withdrawn to pay medical expenses
    • For MSAs, qualified policies are those with deductibles of $1,700 - $2,600 for individuals ($3,450 - $5,150 for families) in 2004
    • Contributions to MSAs are limited to 65% of policy deductible for individuals (75% for families)
health savings accounts11
Health Savings Accounts
  • HSAs are similar to MSAs but with different limits
    • In 2004, individuals with deductibles of at least $1,000 ($2,000 for families) can qualify for a deduction equal to lesser of $2,250 ($4,500 for families) or the annual policy deductible
  • Distributions not spent on qualifying expenses are included in income and subject to a 10% penalty for HSAs and 15% penalty for MSAs
special travel deduction
Special Travel Deduction
  • For nonreimbursed travel expenses to attend National Guard or military reserve meetings more than 100 miles from home
  • Maximum deduction is general government per diem rate for the area
    • Excess expenses can be deducted as miscellaneous itemized deductions (subject to 2% of AGI floor)
filing status
Filing Status
  • Taxpayer’s filing status determines standard deduction and tax rate schedule
  • Marital status determined on the last day of the tax year
    • Separated spouses are considered married until divorce becomes final
filing status married
Filing Status - Married
  • Can file jointly if both spouses are US citizens or US residents (or if nonresident alien agrees to be taxed on worldwide income)
  • If the couple file separately, both must itemize deductions or both must use the standard deduction
surviving spouse
Surviving Spouse
  • Marital status is determined at the date of death so a joint return can be filed for the year in which a spouse dies
  • A surviving spouse may continue to use the tax rates and standard deduction for married persons filing jointly for the next 2 years only if a dependent child lives with the taxpayer
filing status unmarried
Filing Status – Unmarried
  • Unmarried taxpayers file as
    • Head of household - an unmarried person who provides more than half of the cost of maintaining a home in which a child or other qualifying relative lives for more than half the year
    • Single
head of household
Head of Household

Qualifying relatives

  • Unmarried child who lives with the taxpayer for more than half of the taxable year (does not need to be taxpayer’s dependent)
  • A parentof the taxpayer who is a dependent (does not need to live in taxpayer's home)
  • Other qualifying relatives must live with the taxpayer for more than half the year and be a dependent
head of household18
Head of Household
  • Qualifying relatives include brothers, sisters, parents, grandparents, nieces and nephews by blood, aunts and uncles (defined as brother or sister of father or mother)
  • Cousins and more distant relatives are not included in the definition of qualifying relatives
abandoned spouse
Abandoned Spouse
  • A taxpayer who is married but whose spouse did not live with him or her at any time during the last six months of the tax year and who provides more than half the cost of maintaining the home in which a dependent child lives
  • A qualifying abandoned spouse uses head of household tax rates and standard deduction
  • Each taxpayer (who is not a dependent) is entitled to one personal exemption
  • Exemption deduction is $3,100 for 2004
  • Additional exemptions allowed for each person who is considered a dependent
    • Anyone who is claimed as a dependent cannot claim a personal exemption
dependency exemptions
Dependency Exemptions

An individual qualifies as a dependent only if all 5of the requirements are satisfied:

1.Relative or member-of-household test

2. The support test

3. Gross income test

4. Joint return test

5. Citizenship or residency test

relative or member of household test
Relative or Member-of-Household Test
  • The dependent must be either be a qualifying relative (including a child, grandchild, brother, sister, parent, grandparent, niece, nephew, aunt and uncle) or
  • A member of the taxpayer’s household for the entire taxable year
the support test
The Support Test
  • Taxpayer must provide more than 50% of the dependent's total support
    • Support includes amounts spent for food, clothing, shelter, medical care, education and capital expenditures such as a car
    • Value of services and scholarship funds are omitted in determining support received by a student
    • Nontaxable income used for support must be included in support determination
multiple support agreement
Multiple Support Agreement
  • Multiple support agreements allow one member of group of support providers to claim the exemption when
    • Together the group meets the support test
    • All other dependency tests are met
    • Member who claims exemption must provide more than 10% of the total support and other members providing 10% support agree to exemption
gross income test
Gross Income Test
  • The dependent's gross income from taxable sources must be less than the exemption amount ($3,100 for 2004)
  • The gross income test is waived for
    • Child of taxpayer who is under age 19 at year end or
    • Child of taxpayer who is under age 24 at year end and was a full-time student for at least 5 months during the year
phaseout of exemptions
Phaseout of Exemptions
  • Both personal and dependency exemptions are phased out at a rate of 2% (4% for MFS) for each $2,500 (or fraction thereof) of AGI above thresholds
    • $142,700 if single
    • $178,350 if head of household
    • $214,050 if married filing jointly
    • $107,025 if married filing separately
exemption phaseout
Exemption Phaseout

(1) (AGI – threshold AGI)/$2,500 = Phaseout Factor (always round up to next whole number)

(2) Phaseout Factor x 2% = Phaseout Percentage

(3) Exemption Amount x (1 – Phaseout Percentage) = Adjusted Exemption Deduction

  • Once AGI exceeds the threshold AGI by more than $122,500 ($61,250 for MFS) the exemption deduction is completely phased out
standard deductions
Standard Deductions
  • Standard Deductions
    • $9,700 married filing a joint return
    • $4,850 married filing separately
    • $7,100 head of household
    • $4,850 single individual
  • Add on standard deduction if taxpayer is elderly (age 65 or older) or blind
    • $1,200 if single or head of household
    • $950 if married
dependent s standard deduction
Dependent’s Standard Deduction
  • Dependent’s standard deduction is limited to the greater of:

(1) $800 or

(2) Earned income + $250 (up to otherwise allowable standard deduction)

    • Earned income includes salary and wages
    • Earned income does not include interest income, dividend income, capital gains, or income as beneficiary of a trust
itemized deductions
Itemized Deductions
  • Itemized deductions provide tax benefit only to the extent that, in total, they exceed the taxpayer’s standard deduction
  • Taxpayers can maximize use of the standard deduction and itemized deductions by timing certain deductible payments
medical expenses
Medical Expenses
  • Medical expenses paid for the taxpayer, spouse and dependents, after reduction for insurance reimbursements, are deductible only to the extent they exceed 7.5% of AGI for the year
  • Qualified medical costs includes prescription drugs and insulin, costs of a hospital, clinic, doctor, dentist, eyeglasses, contract lenses, transportation for medical care and health insurance costs
medical expenses32
Medical Expenses
  • Health insurance premiums for taxpayers and their dependents are deductible only if paid from after-tax income
    • Premiums paid through an employer-sponsored cafeteria plan are not deductible
    • Premiums for disability insurance and for loss of life, limb or income are not deductible
    • Premiums for long-term care insurance are deductible, subject to limits based on age
  • Deductible taxes include
    • State, local, and foreign real property taxes
    • State and local personal property taxes
    • State, local, and foreign income taxes
    • Other federal, state, local, and foreign taxes incurred in a business or other income-producing activity
nondeductible taxes
Nondeductible Taxes
  • Federal income taxes
  • Employee's share of payroll taxes
  • Federal excise taxes not incurred for business
  • State and local sales taxes on goods for personal use
  • Assessments on property that increase property value
interest expense
Interest Expense
  • Deductible interest includes
    • Investment interest
    • Home mortgage interest
  • No deduction for most other personal interest such as interest on auto loans, life insurance loans, credit card debt, and delinquent tax payments (except previously mentioned student loan interest)
investment interest expense
Investment Interest Expense
  • Investment interest includes interest on loans to acquire or hold investment property and margin account interest paid to a broker
  • Investment interest expense is only deductible to the extent of net investment income
    • Net investment income = excess of investment income over investment expenses
  • Excess is carried forward (indefinitely) subject to same limit in future years
investment interest expense37
Investment Interest Expense
  • Investment incomeincludesgross income from interest, annuities, and short-term capital gains from investment property
    • Long-term capital gains or dividends taxed at favorable rates are excluded unless election made to forgo the favorable rate
  • Investment expenses includes safe deposit box rental fees, investment counsel fees, brokerage account maintenance fees
    • Limited to the lesser of total investment expenses or net miscellaneous itemized deductions after reduction for 2% AGI floor
qualified residence interest
Qualified Residence Interest
  • Interest paid for acquisition debt or home equity debt for up to 2 qualified residences
  • Interest on acquisition debt of up to $1 million principal amount (combined limit for 2 homes) is deductible
    • Acquisition debt includes mortgage to buy, construct, or improve the residence
qualified residence interest39
Qualified Residence Interest
  • Interest on up to $100,000 principal amount of home equity loan is deductible
    • Loan proceeds can be used for any purpose
  • Points (loan origination fees) paid on initial home mortgages are deductible
    • Points paid to refinance an exiting loan must be amortized over life of loan
charitable contributions
Charitable Contributions
  • Congress allows individuals, corporations, estates and trusts to deduct contributions to certain qualified organizations
  • Partnerships and S corporations pass the contributions through to their partners and shareholders who then claim the deductions on their own income tax returns
charitable contributions41
Charitable Contributions
  • Qualified charitable organizations
    • Governmental units (federal, state and local governments) and entities formed and operated exclusively for religious, charitable, scientific, literary or educational purposes, including churches, nonprofit hospitals, school and universities, libraries, and social service agencies
  • Direct contributions to needy individuals are notdeductible
charitable contributions42
Charitable Contributions
  • No deduction allowed to the extent that valuable goods or services are received in return for the contribution
    • Exception - contributors to universities who receive preferred rights to purchase tickets for university athletic events may deduct 80% of the amount of their contribution
  • Individuals can deduct up to 50% of AGI
    • Excess contributions may be carried forward up to 5 years
charitable contributions43
Charitable Contributions
  • No deduction for contributions of the taxpayer’s services and rent-free use of the taxpayer’s property
    • Out-of-pocket costs incurred for volunteer work for a qualifying charity are deductible
  • Property other than long-term capital gain property is valued at lesser of FMV or basis
contributions of ltcg property
Contributions of LTCG Property
  • LTCG property is valued at FMV (which is usually greater than adjusted basis)
    • Tangible personalty given to a charity which does not use the property in its tax-exempt activity is valued at the lower adjusted basis
  • Deduction for LTCG property valued at FMV is limited to 30% of AGI
    • 30% limit can be avoided (and 50% AGI limit applied) if taxpayer elects to use lower basis
    • If made, election applies to all LTCG contributions that year
charitable contributions45
Charitable Contributions
  • Stocks or other income producing property that have declined in value should be sold so that the loss can be claimed with the sale proceeds donated
  • Fees incurred for appraisals of donated property may be deducted as a miscellaneous itemized deductions
casualty and theft losses
Casualty and Theft Losses
  • Loss is the lesser of
    • Asset’s adjusted basis or
    • Decline in asset’s fair market value as a result of the casualty
  • Loss is reduced for any insurance proceeds received
  • $100 floor applies to each casualty
  • Deductible only to extent total losses exceed 10% of AGI
miscellaneous deductions
Miscellaneous Deductions
  • Only excess over 2% of AGI is deductible
    • Unreimbursed employee business expenses
    • Job hunting expenses (in searching for a new job in current line of business)
    • Investment-related expenses
    • Hobby expenses (up to hobby income)
    • Tax preparation and planning advice
phaseout of itemized deductions
Phaseout ofItemized Deductions
  • Total deductions phased out by 3% of AGI in excess of $142,700 in 2004 ($71,350 if MFS)
  • Exception - deductions not phased out for
    • Medical expenses
    • Investment interest
    • Casualty and theft losses
  • Total deductions are not reduced by more than 80% regardless of type
tax rates for married filing a joint return
Tax Rates forMarried Filing a Joint Return
  • For married filing a joint return for 2004
    • 10% on first $14,300 taxable income
    • 15% on $14,301 - $58,100
    • 25% on $58,101 - $117,250
    • 28% on $117,251 - $178,650
    • 33% on $178,651 - $319,100
    • 35% over $319,100
tax rates for married filing separately
Tax Rates forMarried Filing Separately
  • For married filing separately for 2004
    • 10% on first $7,150 taxable income
    • 15% on $7,151 - $29,050
    • 25% on $29,051 - $58,625
    • 28% on $58,626 - $89,325
    • 33% on $89,326 - $159,550
    • 35% over $159,551
tax rates for single individuals
Tax Rates for Single Individuals
  • For single individuals for 2004
    • 10% on first $7,150 taxable income
    • 15% on $7,151 - $29,050
    • 25% on $29,051 - $70,350
    • 28% on $70,351 - $146,750
    • 33% on $146,751 - $319,100
    • 35% over $319,100
tax rates for head of household
Tax Rates for Head of Household
  • For head of household for 2004
    • 10% on first $10,200 taxable income
    • 15% on $10,201 - $38,900
    • 25% on $38,901 - $100,500
    • 28% on $100,501 - $162,700
    • 33% on $162,701 - $319,100
    • 35% over $319,100
special tax rates
Special Tax Rates
  • 28% rate applies to LTCG from collectibles and Section 1202 small business stock
  • 25% rate applies to unrecaptured Section 1250 gain
  • 15% rate on LTCG from the sale of capital assets (applies to taxpayers in higher tax brackets)
    • 5% rate applies to taxpayers in 10% or 15% tax brackets
  • Dividend income is taxed using the capital gain rate of 15% (5% for low-income taxpayers)
credits vs deductions
Credits vs. Deductions
  • Deductions only reduce tax liability by a percentage based on the taxpayer’s marginal tax rate
  • Credits are direct dollar-for-dollar reductions in the gross tax liability
    • Tax credits have the same dollar value to all taxpayers, regardless of their marginal tax brackets
child tax credit
Child Tax Credit
  • $1,000 nonrefundable tax credit for each qualifying child under age 17
    • Qualifying children include the taxpayer’s son, daughter, stepson, stepdaughter, grandchild, or eligible foster child that the taxpayer claims as a dependent
  • Phased out at rate of $50 for every $1,000 (or part thereof) of AGI in excess of
    • $110,000 if married filing jointly ($55,000 if MFS)
    • $75,000 if single or head of household
education credits
Education Credits
  • Two elective nonrefundable tax credits are provided for college or vocational tuition and fees for the taxpayer, spouse, or dependents
    • Hope Scholarship Credit– 100% of first $1,000 and 50% of second $1,000 tuition and fees for first 2 years only (maximum $1,500 per student)
    • Lifetime Learning Credit– 20% of up to $10,000 tuition and fees (maximum $2,000 per taxpayer in 2004)
    • A student who is a dependent cannot claim the credit
education credits57
Education Credits
  • Expenses paid with a Pell Grant, scholarship, or employer-provided educational assistance do not qualify
  • The election is separate for each student, so a parent may choose one credit for one child and a different credit for a second child
  • Both credits phase out over modified AGI of
    • $42,000 - $52,000 if single
    • $85,000 - $105,000 if married filing jointly
earned income credit
Earned Income Credit
  • The purpose is to reduce the impact of payroll taxes for low-income individuals
  • Credit is equal to a percentage of earned income below a maximum
    • With one qualifying child maximum credit is $2,604 ($7,660 x 34%)
    • With two or more qualifying children maximum credit is $4,300 ($10,750 x 40%)
    • Smaller credit available to taxpayers without children
earned income credit59
Earned Income Credit
  • This is a refundable credit
  • Taxpayers with investment income of $2,650 or more are not eligible
  • Anyone who can be claimed as a dependent is not eligible
  • A taxpayer without a qualifying child, must be between the ages of 25 through 64 to be eligible
dependent care credit
Dependent Care Credit
  • Nonrefundable credit for taxpayers who pay for child or dependent care so they can work
  • Credit percentage varies from 20% to 35% of up to $4,000 for one qualifying child or $6,000 for 2 or more qualifying children under 13
    • 35% if AGI does not exceed $15,000
    • Reduced by 1% for each $2,000 (or fraction thereof) AGI exceeds $15,000
    • 20% if AGI exceeds $43,000
retirement contributions credit
Retirement Contributions Credit
  • To encourage participation by low-income wage earners, a credit for up to $2,000 contributed to employer-sponsored retirement plans or IRAs is available
  • Credit varies with AGI
    • 50% credit for joint filers with AGI up to $30,000 ($15,000 if single)
    • 20% for joint filers with AGI of $30,000 - $32,500 ($15,000 - $16,250 if single)
    • 10% for joint filers with AGI of $32,500 - $50,000 ($16,250 - $25,000 if single)
    • Dependents or full-time students are not eligible
excess payroll tax credit
Excess Payroll Tax Credit
  • Taxpayers working for more than one employer during the year with earnings exceeding the Social Security ceiling ($87,900 for 2004) usually have too much tax withheld
  • Employee is allowed a credit for any excess Social Security taxes withheld
alternative minimum tax
Alternative Minimum Tax
  • The purpose of the alternative minimum tax is to ensure high-income taxpayers pay their fair share of tax
  • Certain deductions are disallowed or reduced and certain exempt income items are subject to the AMT
  • IF AMT is greater than the regular tax, taxpayers pay the larger amount
  • Rate is 26% on first $175,000 and 28% on excess for individuals
amt model
AMT Model

Taxable income

Plus/minus Adjustments to taxable income

Plus: Tax preferences

Less: Allowable exemptions

Equals: Alternative minimum taxable income

Times: AMT tax rates

Equals: Tentative minimum tax (TMT)

Less: Regular income tax

Equals: AMT

amt exemptions
AMT Exemptions
  • AMT exemptions for 2004 are
    • $58,000 if married filing jointly
    • $29,000 if married filing separately
    • $40,250 if single or head of household
  • Exemptions begin to phase out when AMTI reaches $112,500 for singles and $150,000 for married filing jointly ($75,000 if MFS) at a rate of $1 for every $4 above the threshold
alternative minimum tax66
Alternative Minimum Tax
  • Itemized deductions are different from those calculated for regular income tax
    • Medical expenses must exceed 10% AGI
    • Taxes, home equity loan interest, and miscellaneous itemized deductions are not deductible
  • Tax preferences that are added include
    • Nontaxable interest on private activity bonds
    • Bargain element of incentive stock options
payment of income tax
Payment of Income Tax
  • Estimated quarterly payments are made by persons with large amounts of income from sources not subject to withholding
    • Due on April 15, June 15, September 15 of current year and January 15 of following year
  • If payments are not 90% or more of the total tax owed (or an amount required based on the prior year’s tax), a penalty may be charged, unless balance due is less than $1,000
filing requirements
Filing Requirements
  • Any taxpayer whose gross income is less than the sum of their standard deduction and their personal exemption (but not dependency exemptions) does not have to file a tax return
    • $7,950 in 2004 for a single individual
  • Returns should be filed if
    • Net self-employment income is $400 or more
    • A child claimed as a dependent has unearned income only of over $800
    • Any married person filing separately has income over $3,100