Taxation Of Individuals

1
Taxation of Business Entities

• Chapter 16 and 17
• Taxation Of Individuals

2
Outline

• Review of Individual Tax Formula and Gross Income
  Inclusions and Exclusions
• Standard Deduction vs. Itemized Deductions
• Personal and Dependency Exemptions
• Kiddie Tax
• Filing Status
• Specific Inclusion and Exclusion Rules applicable
  to Individuals
• Itemized Deductions
• Child Tax Credit
• Education Tax Credit
• Employment-Related Expenses

3
Tax Formula

• Income(broadly conceived) x,xxx
• LessExclusions (x,xxx)
• Gross Income x,xxx
• LessDeductions for AGI (x,xxx)
• Adjusted Gross Income (AGI) x,xxx
• Less
• The greater of total itemized deductions
• or the standard deduction (x,xxx)
• Personal dependency exempts (x,xxx)
• Taxable Income x,xxx

4
Components of the Tax Formula

• Income
• A partial list of gross income items is provided
  in Exhibit 16-2
• Exclusions- common items listed in Exhibit 16-1
• See lines 7-21 of 1040
• Deductions for Adjusted Gross Income include (see
  lines 23-35 of 1040)
• 1/2 of self-employment tax paid
• Alimony paid
• Payments to qualified retirement plans (lines 28,
  and 32)
• Continued on next slide

5
FOR AGI Deductions (cont)

• Educator Expense - 250
• Health Savings Account (16-37 thru 16-38)
• For taxpayers with high-deductible health
  insurance plans, allows them to pay for
  out-of-pocket expenses with before tax dollars
• SE Health Insurance deduction (17-41)
• Moving Expenses job related (17-24 thru 17-26)
• Student Loan Interest max 2,500 (16-41)
• Subject to phase out MAGI gt 55,000 (115,000
  MFJ)
• Tuition and Fees Deduction (17-29 thru 17-30)
• Max deduction 4,000
• Eligibility depends on MAGI

6
Components of the Tax Formula Adjusted Gross
Income (AGI)

• Important subtotal that serves as
• basis for computing percentage limitations for
  certain itemized deductions
• Medical expenses (7½ of AGI Floor)
• Personal Casualty Loss deduction (10 of AGI
  Floor)
• Charitable Contribution (50 of AGI Ceiling)
• basis for determining the phase-out of
• Itemized deductions
• Personal and dependency exemptions
• Child Credit and Education Credits
• Small Landlord Deduction
• Basis for determine eligibility for certain
  items
• Roth IRA
• Traditional IRA
• Earned income Credit

7
Components of the Tax Formula

• Itemized Deduction vs. Standard Deduction
• Taxpayers are allowed to deduct the greater of
  total itemized deductions (less phase-out amount)
  or the standard deduction
• Itemized Deductions include certain personal
  expenses medical expenses, interest, taxes,
  charitable contributions, personal casualty
  losses, and certain other miscellaneous expenses
  (see schedule A)
• The Standard Deduction includes three possible
  components
• Basic Standard Deduction
• Additional Standard deduction over 65 and/or
  blind
• Property Tax Deduction for 2008 and 2009 only

8
Standard Deductions

• The basic standard deduction (BSD)

Filing status 2008 w/prop tax Single
5,450 5,950 MFJ, SS 10,900 11,900 HH
8,000 8,500 MFS
5,450 5,950 for 2008 and 2009 basic standard
deduction can be increased by the lesser of
1)real property taxes paid during year or 2) 500
(1,000 for married filing joint). 2008 tax law
change
9
Standard Deductions

• Additional standard deduction (ASD)
• For taxpayers age 65 or older and/or legally blind

Filing status 2008 Single
1,350 MFJ, SS
1,050 HH 1,350
MFS 1,050

10
Standard Deduction

• Examples (2008 tax year)
• Taxpayer is single, pays property taxes of 3,000
  and is over age 65
• Taxpayers are married, filing jointly, pay
  property taxes of 4,000 and are both over age 65
  

11
Standard Deductions

• Taxpayers who are ineligible to use the SD
• Married, filing separately, when other spouse
  itemizes deductions
• Nonresident aliens
• Individual filing return for tax year of less
  than 12 months

12
Standard Deductions

• Special limitations on BSD for dependents
• Individual claimed as dependent has a BSD limited
  to the greater of
• 900 or
• 300 plus earned income (but not exceeding normal
  BSD)
• Earned income means income from a job or
  trade/business income. Does not include
  investment income.
• Dependents SD (2008 tax year)
• What is the standard deduction for a child who
  earns 1,500 in wages and is claimed by parents
  as a dependent?

13
Personal and Dependency Exemptions

• 2008 3,500 per exemption
• Personal Exemption
• One per taxpayer
• two personal exemptions when married, filing
  jointly
• Personal exemption allowed on joint return for
  spouse who dies during the year
• If taxpayer claimed as a dependent on someone
  elses tax return, then can not also claim a
  personal exemption on his/her own tax return
• Dependency Exemption allowed for
• Qualifying Child
• Qualifying Relative

14
Dependency Exemptions

• Qualifying Child
• Relationship (blood, marriage or adoption)
• Son, daughter, sibling, grandchild, niece or
  nephew
• Domicile
• Same principal residence as taxpayer for more
  than half the year
• Children of divorced parents are claimed by
  custodial parent, unless written agreement
  allowing non-custodial parent to claim deduction
• Age
• Under 19 OR
• Under 24 and full-time student
• If disabled, there is no age limit
• Must also meet joint return test and (usually)
  U.S. citizen or resident of U.S., Canada, or
  Mexico

15
Dependency Exemptions

• Qualifying Relative - must meet ALL of the
  following tests
• support
• relationship
• gross income
• joint return
• citizen/residency

16
Support Test

• Taxpayer must provide more than 50 of the
  qualifying relatives support
• Only amounts expended are considered in the
  support test
• Scholarships received by student not considered
  in the support test
• Exception to support test requirement Multiple
  Support Agreement
• Allows group providing gt half support to claim
  individual even though no one person provides gt
  50 support
• Eligible parties must provide gt 10 of support
• Each eligible party must meet all other
  dependency requirements
• Example- Allows children of elderly parent to
  claim exemption for parent when none individually
  meets the 50 support test

17
Relationship Test

• Relationship (or household member)
• Dependent must be one of the specified relatives
• qualifying child definition (e.g. child, sibling)
• lineal ascendants (e.g. parent, grandparent)
• collateral ascendants (e.g. aunt, uncle)
• Certain in-laws (e.g. son, daughter, father,
  mother, brother, sister)
• or be a member of the taxpayers household for
  the entire year
• Once a relationship is established by marriage,
  it continues even if there is a change in marital
  status

18
Gross Income Test

• Gross income
• Dependents gross income (subject to tax) must be
  less than amount allowed for an exemption (i.e.,
  3,500 for 2008)
• Example of gross income test (2008 tax year)
• Grandparent (age 70) meets all dependency tests
  for taxpayer except has pension income of 4,500
  and social security income of 8,000. Can he be
  claimed as a dependent? What if he only had
  social security income?

19
Other Tests

• Joint return
• Dependent cannot file a joint return with spouse
  unless
• Filing solely for refund of all taxes withheld
• No tax liability exists for either spouse
• Neither spouse required to file return
• Citizen or residency
• Dependent must be a U.S. citizen or a resident of
  U.S., Canada, or Mexico

20
Phase Out of Exemptions

• Phase-out of exemption benefits applies when
  taxpayers AGI in 2008 exceeds
• 239,950 for married, filing jointly, or
  surviving spouse
• 195,950 for head of household
• 159,950 for single
• 119,975 for married, filing separately
• Exemptions deduction is reduced by 2 for every
  2,500 (1,250 for MFS) or part thereof, that AGI
  exceeds threshold amounts
• For 2008 the phase-out amount calculated using
  this formula is reduced by 2/3
• Minimum exemption amount for 2008 2,333

21
Phase-Out Example

• 2008, MFJ, 2 kids How much is allowed for
  personal and dependency exemptions if
• AGI 100,000
• AGI 275,000

22
Kiddie Tax

• Net unearned income (NUI) of child (if claimed as
  dependent) is taxed at parents rate
• Child under age 19 (or under 24 and fulltime
  student)
• NUI generally equals unearned income less 1,800
• Unearned income includes taxable interest,
  dividends, capital gains, rents, royalties,
  pension and annuity income, and unearned income
  from trusts
• NUI taxed at parents rate
• Remainder of childs taxable income is taxed at
  childs rate

23
Kiddie Tax Example

• In 2008, Son claimed as dependent on parents
  return has interest income of 2,900 and wages of
  500. Parents rate is 35.
• How much tax is owed on Sons income if son is 25
  and a full-time student?
• How much tax is owed on Sons income if son is 20
  and a full-time student?

24
Filing Status

• There are 5 filing statuses
• Single
• Married, filing jointly
• Surviving spouse (qualifying widow or widower)
• Head of household
• Married, filing separately
• Filing status affects tax rate brackets, standard
  deduction, phase-out limits, limits on
  eligibility for certain deductions/credits (e.g.
  IRA, SS thresholds, child tax credit, etc)

25
Filing Status

• Married Filing Joint
• Legally married last day of tax year
• Dont have to be living together
• Must have same tax year-end date
• Both must be U.S. citizens or residents
• MFJ can be used in year of spouses death
• Surviving Spouse
• Allows surviving spouse to use MFJ rates for two
  years after spouses death if following
  requirements met
• Qualified for MFJ in year of death, and has not
  remarried
• Has at least one dependent child living at home
  during the entire year (must be a tax dependent)
• Pays over 50 of expenses of the home

26
Filing Status

• Head of Household
• Single on last day of tax year
• Or if legally married, meets married persons who
  live apart criteria - Lived apart last 6 months
  of the year
• U.S. Citizen or resident
• Pays over 50 of the expenses of the household in
  which a dependent relative lives for more than
  half the year
• Single
• All unmarried taxpayers who do not qualify for
  Surviving Spouse or Head of Household status
• Married Filing Separately an option for married
  taxpayers, usually not financially beneficial

27
Payments Pursuant to Divorce

• Alimony Payments (cash payments pursuant to
  divorce or separation agreement)
• Deductible by payor
• Includible in gross income of recipient
• Property settlements
• Transfer of property to former spouse
• No deduction or recognized gain or loss for payor
• Carryover of payors basis for recipient (not
  considered income to recipient)
• Child support payments
• Payments made to satisfy legal obligation to
  support child of taxpayer
• Nondeductible by payor and not taxed to recipient
  (or child)

28
Special Rules for Individual Gross Income Items

• Prizes and Awards - General rule is that FMV of
  item is included in income
• Exceptions
• Taxpayer designates qualified organization to
  receive prize or award
• Employee awards of tangible personal property
  made in recognition of length of service or
  safety achievement
• Unemployment Compensation Taxable in Full
• Social Security Benefits -Up to 85 of benefits
  may be taxable
• Taxability based on taxpayers modified adjusted
  gross income (MAGI)
• MAGI AGI foreign earned income exclusion
  tax exempt interest ½ Social Security Benefit

29
Gifts and Inheritances

• Gifts are nontaxable to donee if
• Transfer is voluntary without adequate
  consideration, and
• Made because of affection, respect, admiration,
  charity, or donative intent
• Inheritances are nontaxable to beneficiary
• Income earned on gifts or inheritances taxable to
  recipient under normal rules
• Transfers by employers to employees do not
  qualify as excludible gifts
• May be excludible under other provisions, e.g.,
  employee achievement awards

30
Scholarships and Fellowships

• An amount paid to or for the benefit of a student
  to aid in pursuing a degree at an educational
  institution
• Nontaxable to extent of tuition and related
  expenses (e.g., fees, books, and equipment
  required for courses)
• Amounts received for room and board are taxable

31
Compensation for Injuries and Sickness

• Personal injury damages
• Compensatory damages received due to physical
  personal injury are excludible
• All other personal injury damages taxable
• Compensatory damages for nonphysical injury (e.g.
  loss of reputation)
• All punitive damages
• Payments solely for loss of income are also
  taxable (unless relate to a physical injury)
• Workers compensation
• Although may be payment for loss of wages,
  workers compensation is specifically excluded
  from gross income
• Accident and health insurance benefits
• Benefits received under policy purchased by
  taxpayer excludible- even if substitute for
  income

32
Itemized Deductions

• Personal expenditures that are deductible FROM
  AGI as itemized deductions include
• Medical
• Certain taxes
• Certain interest expense
• Charitable Contributions (covered in Ch. 5)
• Casualty Losses (covered in Ch. 6)
• Miscellaneous
• Itemized deductions provide a tax benefit only to
  extent that in total they exceed the standard
  deduction amount for the taxpayer

33
Medical Expenses

• Expenses paid for diagnosis, cure, mitigation,
  treatment or prevention of disease for taxpayer,
  spouse and dependents
• Must be paid with after-tax dollars (e.g. not
  from a flexible spending account) and not
  compensated by insurance
• Includes cost of insurance and travel (if
  necessary)
• See Exhibit 16-4 for examples of deductible and
  non-deductible expenses
• There is a 7.5 of AGI floor thus only those
  expenses in excess of 7.5 of AGI are deductible

34
Taxes

• State and Local Income Taxes or State Sales Tax
  (2008 and 2009)
• Cash Basis taxpayers deduct when paid
• Real Estate Taxes
• Local benefit items are non-deductible
• If property sold during year, must be apportioned
  between buyer and seller
• Personal Property Tax
• If ad valorem tax (i.e. based on value) imposed
  on annual basis then tax is deductible

35
Interest

• Home Mortgage Interest
• Qualified Residences (up to 2)
• Aggregate maximum acquisition indebtedness
  1,000,000
• Points paid on loan to purchase or improve
  residence also deductible
• Otherwise capitalize and amortize
• Home Equity Loan Interest deductible on loan
• Maximum loan principal is lesser of
• 100,000 or
• FMV of residence less acquisition indebtedness
• Investment Interest Expense
• Deductible to the extent of net investment income
  (which does not include any gains/income subject
  to preferential tax rates)
• Any non-deductible amount can be carried-forward

36
Investment Interest Example

• In 2008 t/p has investment interest expense of
  10,000 and investment income consisting of
• LTCG 4,500
• Interest Income 3,200
• How much of the 10,000 can t/p deduct in 2008?
• If no special election made for LTCG
• If elects treat LTCG as ordinary income

37
Charitable Contributions

• Rules learned in Chapter 5 govern the
  determination of the deductible amount for
  non-cash property
• Maximum limit for individuals
• Generally 50 of AGI
• Reduced to 30 of AGI for LTCG property or
  property contributed to non-operating private
  foundation
• Can carryover amounts that exceed limit
• There are strict substantiation requirements

38
Miscellaneous I.D.

• Subject to 2 of AGI Floor
• Unreimbursed employee business expenses
• Job hunting costs
• Investment related expenses (other than interest)
• Hobby related expenses (to the extent of hobby
  income)
• Tax advice/preparation expenses
• NOT subject to a floor
• Gambling losses (to the extent of gambling
  winnings)
• Other (obscure) deductions

39
Phase-out of I.D.

• Itemized Deductions are subject to phase-out for
  high-income taxpayers.
• 2008 threshold 159,950 (79,975 for MFS)
• Phase out amount 3 X (AGI threshold
  amount).
• However for 2008 and 2009 the phase-out ITSELF is
  being phased.
• Actual phase-out amount computed above X 1/3
• The book also provides an alternative
  calculation. The phase-out is the lesser of the
  two. However, the vast majority of the time the
  lesser amount is the 3 amount.

40
Itemized Deductions Phase Out Example

• MFJ Taxpayers with AGI 235,000 and two
  dependent children have itemized deductions of
  20,000 (before phaseout).
• Compute their taxable income.

41
Common Credits Available to Individuals

• Child and Dependent Care Credit Credit ranges
  from 20-35 (depending on income) of qualifying
  expenses up to 3,000 per qualifying child
  (maximum of 6,000 for 2 or more qualifying
  children). (pg 16-54)
• Earned Income Credit refundable credit (i.e.
  can result in negative income tax payments) for
  low-income taxpayers with dependent children.
• Adoption Expense Credit up to 11,650 in 2008,
  phased-out begins at AGI of 174,730. Completely
  phased-out for AGI of 214,730.
• Child Credit
• Education Credits
• New Home Buyers Credit 2008 and 2009 only

42
Child Tax Credit

• Credit amount
• 1,000 per qualifying child through 2010
• Eligible children are
• Under age 17,
• US citizen, and
• Claimed as dependent on taxpayers tax return
• Credit is phased out by 50 for each 1,000 of
  AGI above specified levels
• 110,000 for joint filers
• 55,000 for married filing separately
• 75,000 for single, Head of Household

43
Child Tax Credit - Example

• MFJ have 2 qualifying children and AGI -
  120,000. How much is their child credit?

44
Education Tax Credits

• 2 education tax credits available
• Hope scholarship credit
• Lifetime learning credit
• Both nonrefundable credits are available for
  qualifying tuition and related expenses
• Room, board, and book costs are NOT eligible
• Eligible individuals include
• Taxpayer,
• Spouse, and
• Taxpayers dependent
• To be eligible for Hope credit, student must take
  at least 1/2 of full-time course load
• No such requirement for lifetime learning credit

45
Education Tax Credits

• Maximum credits
• Hope scholarship credit maximum per eligible
  student is 1,800 per year for first 2 years of
  postsecondary education
• 100 of first 1,200 of tuition expenses plus 50
  of next 1,200 of tuition expenses
• Lifetime learning credit maximum per taxpayer is
  20 of qualifying expenses
• Max qualifying expenses is 10,000
• Cannot be claimed in the same year the Hope
  credit is claimed for a particular student

46
Education Tax Credits

• Income Limitations
• Both education credits are combined and phased
  out for AGI of 96,000 to 116,000 for married
  filing jointly and 48,000 to 58,000 for others
• Taxpayers cant receive a double tax benefit for
  education expenses
• Cant claim a credit for amounts otherwise
  excluded from income (e.g., scholarships and
  employer-paid education assistance)

47
Education Tax Credits - Example

• MFJ T/P with AGI 102,000 in 2008 pays the
  following
• 5,000 tuition for 18-year old son who is a
  college freshman
• 4,000 tuition for wife who is pursuing masters
  degree
• What is the total education credits allowed?

48
Qualified Employee Fringe Benefits

• Cost tax-deductible by employer
• Value not included in employees gross income
• Examples
• Health insurance
• Life insurance
• Child care furnished by employer
• Other (see Concept Summary 17-1 pg. 20)
• Note Retirement and pension plans are generally
  tax-deferred for the employee, not tax-free
• Taxes are paid when funds are withdrawn
• EXCEPTION ROTH IRA

49
Employment Related Expenses

• Certain employment-related expenses incurred by
  individuals may be deductible
• Travel
• Transportation
• Meals and Entertainment
• Office-in-Home
• Education Expenses
• Moving Expenses
• All involve detailed rules for how much can be
  deducted (see ch. 17 pages 19 34 for specifics)

50
Employment Related Expenses

• WHO (i.e. employer or employee) deducts the
  expense and WHERE (FOR vs. FROM AGI) depends upon
  the following
• Is Individual Self-employed?
• If individual is an Employee, are they
  reimbursed?
• If they ARE reimbursed are they are reimbursed
  under an accountable plan?
• Accountable plan requires employees to
• Adequately substantiate expenses
• Return any excess reimbursement or allowance.

51
Business Expense Deduction Flowchart(e.g.
travel, transportation, meals, entertainment,
education, office-in-home)
52
Self-Employment Tax

• Net Self-employment income of at least 400
  required to pay self-employment tax
• 2008 rates
• Social Security 12.4 off first 102,000 net
  self-employment income
• Medicare 2.9 of all net self-employment income
• Self-employment income
• Schedule C Income (sole-proprietorship income,
  1099 non-employee compensation)
• Schedule E Ordinary income from partnerships
  including guaranteed payments
• Schedule F (farm income)
• Net Self-employment income SE Income .9235
• Taxpayers receive a FOR AGI deduction for 50 of
  self-employment tax paid