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ACCT 307 Spilker 11e

Chapter 4: Individual Income Tax Overview, Dependents, and Filing Status

The Individual Income Tax Formula

Gross income

Minus: For AGI (above the line) deductions

Equals: Adjusted gross income (AGI)

Minus: From AGI (below the line) deductions

Greater of (a) standard deduction or (b) itemized deductions and 

Deduction for qualified business income (QBI deduction)

Equals: Taxable income

Times: Tax rates

Equals: Income tax liability

Plus: Other taxes

Equals: Total tax

Minus: Credits

Minus: Prepayments

Equals: Taxes due or (refund)

Individuals report taxable income to the IRS on Form 1040

Gross income

  • S. tax laws use all-inclusive income concept.
  • Realized income is the measurable change in property rights.  o Recognized income is what is reported on the tax return
  • Excluded income is income never included in taxable income (e.g., municipal bond interest, gain on sale of personal residence)
  • Deferred income is income included in a subsequent tax year (e.g., installment sales, likekind exchanges)

Character of income (Example 4-1)

  • Tax-exempt income is not taxable
  • Tax-deferred is not taxable in the current year
  • Ordinary income is taxed at the ordinary rates from tax rate schedule
  • Qualified dividends are taxed at 0%, 15%, or 20% depending on taxpayer’s income level.
  • Capital gain or loss depends on whether short-term or long-term o If capital asset is held more than a year, gain or loss is long-term; otherwise it is shortterm
    • Net long-term gains taxed at preferential rates.
    • Capital assets are generally all assets except accounts receivable, inventory, and assets used in trade or business
    • Net long-term capital gains in excess of net short-term capital losses are generally taxed at 0%, 15%, or 20% depending on the taxpayer’s taxable income.
    • Short-term capital gains taxed at ordinary rates.
    • Net capital losses (losses in excess of gains for year): $3,000 deductible against ordinary income for year, losses in excess of $3,000 are carried forward

Deductions (Examples 4-2, 4-3)

  • Deductions for AGI o Deductions above the line to determine AGI o Reduce taxable income dollar for dollar o See Exhibit 4-5 for some common for AGI deductions
  • Deductions from AGI o Deducted from AGI to determine taxable income o Deduction for qualified business income o Greater of standard deduction or itemized deductions o See Exhibit 4-6 for the primary categories of itemized deductions o See Exhibit 4-7 for the standard deduction amounts by filing status

Income tax calculation (Example 4-4)

  • Progressive tax rate schedule
  • Long-term capital gains and qualified dividends are taxed at preferential rates
  • See Appendix D for the tax rate schedules

Other taxes

  • Alternative minimum tax (AMT)
  • Self-employment (SE) taxes
  • 8% net investment income tax (NIIT)
  • 9% additional Medicare tax

Tax credits reduce tax liability dollar for dollar

Tax prepayments (Example 4-5)

  • Income taxes withheld from wages by employer
  • Estimated tax payments made during the year
  • Taxes overpaid in prior year and applied toward current year’s liability

Dependents of the Taxpayer

Relevant for determining filing status, eligibility for certain tax credits, and other tax-related computations.

Dependency requirements

  • Must be a citizen of United States or resident of United States, Canada, or Mexico
  • Must not file joint return with spouse (exception—if no tax liability filing jointly or separately)
  • Must be a qualifying child or a qualifying relative of taxpayer

Qualifying child (Examples 4-6, 4-7)

  • Relationship test: Taxpayer’s son, daughter, stepchild, an eligible foster child, brother, sister, half-brother, half-sister, stepbrother, stepsister, or a descendant of any of these relatives
  • Age test: Child must be younger than the individual claiming the child as a qualifying child and either
    • Under age 19 at the end of the year,
    • Under age 24 at the end of the year and a full-time student, or o Permanently and totally disabled.
  • Residence test: Same residence as taxpayer for more than half the year (exception for temporary absences such as education)
  • Support test: Child must not provide more than half of his or her own support. (Scholarships of actual child (not grandchild, for example) are excluded from support computation.)
  • Tiebreaking rules o Parent over nonparent o If both parents, based on who child resided with most. o If same, parent with higher AGI o If nonparents, highest AGI gets exemption

Qualifying relative (Examples 4-8, 4-9)

  • Relationship test o A descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent),
    • A sibling of the taxpayer, including a stepbrother or stepsister o A son or daughter of the taxpayer’s brother or sister (not cousins) o A sibling of the taxpayer’s mother or father
    • An in-law (mother-in-law, father-in-law, sister-in-law, or brother-in-law) of the taxpayer o An unrelated person who lives in taxpayer’s home entire year
  • Support test: Taxpayer must pay more than half of living expenses (support). (Scholarships of actual child excluded) 
  • Gross income test: Gross income less than $4,200 in 2019

Filing Status (Examples 4-10, 4-11, 4-12, 4-13, 4-14)

Married filing jointly

  • Must be married on the last day of the year
  • If one spouse dies, the surviving spouse is considered to be married to decedent spouse at year-end. (Exception—The surviving spouse remarries before year’s end)
  • Joint and several liability for tax

Married filing separately

  • Taxpayers are married but file separate returns
  • Typically not beneficial from tax perspective (tax rates and other tax benefits)
  • May be beneficial for nontax reasons (no joint and several liability)

Qualifying widow or widower (surviving spouse)

  • Available for the 2 years following the year of spouse’s death
  • Surviving spouse does not qualify if remarries during 2-year period
  • Surviving spouse must maintain household for dependent child

Single

  • Unmarried unless qualifying for head of household

Head of household

  • Unmarried or considered unmarried at end of year [See discussion of married individuals treated as unmarried (abandoned spouses) below.]
  • Not a qualifying widow or widower
  • Pay more than half the costs of keeping up a home during the year
  • Lived in taxpayer’s home with a “qualifying person” for more than half of the year

(dependent parent is not required to live with taxpayer) 

Married individuals treated as unmarried (abandoned spouse)

  • Married at end of year (or is not legally separated from the other spouse)
  • Does not file a joint tax return with the other spouse
  • Pays more than one-half the cost of maintaining a household that serves as principal abode for a qualifying child for more than half the year
  • Lived apart from the other spouse for the last 6 months of the year (other than temporary absences)
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