Individual Income Taxation

1
CHAPTER 3

• Individual Income Taxation
• Tax Determination, Personal Dependency
  Exemptions

2
Tax Formula (slide 1 of 2)

• Income(broadly conceived) x,xxx
• LessExclusions (x,xxx)
• Gross Income x,xxx
• LessDeductions for AGI (x,xxx)
• AGI x,xxx
• LessThe greater of
• Total itemized deductions
• or the standard deduction (x,xxx)
• Personal dependency exemptions (x,xxx)
• Taxable Income x,xxx

FIGURE 31
3
Tax Formula (slide 2 of 2)

• Tax on taxable income (see Tax Tables or
• Tax Rate Schedules) x,xxx
• Less Tax credits (including income
• taxes withheld and prepaid) (xxx)
• Tax due (or refund) xxx

FIGURE 31
4
Income - Broadly Conceived

• Includes all the taxpayers income, both taxable
  and nontaxable
• Essentially equivalent to gross receipts
• It does not include a return of capital or
  receipt of borrowed funds

5
Partial List of Gross Income Items (slide 1 of 2)

• Alimony
• Annuities (income element)
• Awards
• Back pay
• Bargain purchase from employer
• Bonuses
• Breach of contract damages
• Business income
• Clergy fees
• Commissions
• Compensation for services
• Death benefits
• Debts forgiven
• Directors fees

• Hobby income
• Interest
• Jury duty fees
• Living quarters, meals (unless furnished for
  employers convenience)
• Mileage allowance
• Military pay (unless combat pay)
• Notary fees
• Partnership income
• Pensions
• Prizes
• Professional fees
• Punitive damages

6
Partial List of Gross Income Items (slide 2 of 2)

• Dividends
• Embezzled funds
• Employee awards (in certain cases)
• Employee benefits (except certain fringe
  benefits)
• Estate and trust income
• Farm income
• Fees
• Gains from illegal activities
• Gains from sale of property
• Gambling winnings
• Group term life insurance, premium paid by
  employer (for coverage over 50,000)

• Rents
• Rewards
• Royalties
• Salaries
• Severance pay
• Strike and lockout benefits
• Supplemental unemployment benefits
• Tips and gratuities
• Travel allowance (in certain cases)
• Wages

7
Deductions - Individual Taxpayers

• Individual taxpayers have two categories of
  deductions
• Deductions for adjusted gross income (AGI)
• Sometimes known as above-the-line deductions
• Deductions from adjusted gross income

8
Deductions For AGI

• Deductions for AGI include
• Ordinary and necessary expenses incurred in a
  trade or business
• One-half of self-employment tax paid
• Alimony paid
• Certain payments to an IRA and Health Savings
  Accounts
• Moving expenses
• Forfeited interest penalty for premature
  withdrawal of time deposits
• The capital loss deduction, and
• Others

9
Deductions From AGI

• Deductions from AGI include
• The greater of
• Itemized deductions, or
• The standard deduction
• Personal and dependency exemptions

10
Personal and Dependency Exemption Amounts

• Amounts
• 2006 3,300 per exemption
• 2007 3,400 per exemption
• Personal and dependency exemptions
• One per taxpayer (two personal exemptions when
  married, filing jointly) and for each dependent
• Exception Individual claimed as dependent by
  another taxpayer does not receive a personal
  exemption

11
Dependency Exemptions

• A dependency exemption is available for one who
  is either a qualifying child or a qualifying
  relative

12
Dependency Exemptions

• One objective of the Working Families Tax Relief
  Act of 2004 (WFTRA of 2004)
• Establish a uniform definition of qualifying
  child for purposes of the
• Dependency exemption
• Head-of-household filing status
• Earned income tax credit
• Child tax credit
• Credit for child and dependent care expenses

13
Qualifying Child

• Must meet four tests
• Residency test - live with taxpayer more than 6
  months
• Relationship test - son, daughter, brother,
  sister, or descendant (limited)
• Age test - under 19 (or under 24 if full-time
  student)
• Support test - child cannot provide more than
  half his own support

14
Relationship Test

• The child must be the taxpayers
• Son or daughter
• Stepson or stepdaughter
• Brother or sister
• Stepbrother or stepsister
• Half brother or half sister, or
• A descendant of such individual (e.g.,
  grandchildren, nephews, nieces)
• A child who has been adopted, or whose adoption
  is pending, qualifies
• A foster child may also qualify

15
Abode Test

• A qualifying child must live with the taxpayer
  for more than half of the year
• Temporary absences from the household due to
  special circumstances (e.g., illness, education)
  are not considered

16
Age Test

• The child must be under age 19 or under age 24 in
  the case of a student
• A student is a child who, during any part of five
  months of the year, is enrolled full time at a
  school or government-sponsored on-farm training
  course
• Individuals who are disabled are not subject to
  the age test

17
Support

• To be a qualifying child, the individual must not
  be self-supporting
• Cannot provide more than one-half of his or her
  own support
• In the case of a full-time student, scholarships
  are not considered to be support

18
Children of Divorced Parents

• For post 1984 divorce decrees, custodial parent
  gets exemption for children
• This is no longer true starting in 2005.
• Noncustodial parent may claim exemption for
  children if custodial parent signs a Release of
  Claim to Exemption, Form 8332

19
Children of Divorced Parents

• A special rule grants the dependency exemption to
  the noncustodial parent if the divorce (or
  separate maintenance) decree so specifies or the
  custodial parent issues a waiver
• To qualify under this special rule, the parents
  must
• Provide more than half of the support (either
  jointly or singly) of the child
• Have custody (either jointly or singly) of the
  child (or children) for more than half of the
  year
• If this special rule does not apply, the
  dependency exemption is awarded under the
  qualifying child or qualifying relative rules

20
Tiebreaker Rules

• In situations where a child may be a qualifying
  child for more than one person
• Tiebreaker rules specify which person has
  priority in claiming the dependency exemption

21
Qualifying Relative

• If not a qualifying child, then three similar
  tests must be met
• Relationship test - must either be a qualifying
  relative of the taxpayer or a resident in the
  taxpayers household for the entire year
• Gross income test - the qualifying relative's
  gross income from taxable sources must be less
  than the exemption amount
• Support test

22
Relationship Test

• The relationship test for a qualifying relative
  is more expansive than for a qualifying child.
  Also included are the following relatives
• Lineal ascendants (e.g., parents, grandparents)
• Collateral ascendants (e.g., uncles, aunts)
• Certain in-laws (e.g., son-, daughter-, father-,
  mother-, brother-, and sister-in-law)
• The relationship test also includes unrelated
  parties who live with the taxpayer

23
Gross Income Test

• Dependents gross income must be less than the
  exemption amount (3,400 for 2007)

24
Support Test

• Taxpayer must provide more than 50 of the
  qualifying relatives support
• Only amounts expended are considered in the
  support test
• Scholarships are not considered in the support
  test
• Two exceptions to the support test
• Multiple support agreements
• Children of divorced parents

25
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
• Dependents nontaxable income used for support
  must be included in support determination

26
Multiple Support Agreements

• Allows one member of a group providing gt 50 of
  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

27
Other Rules for Dependency Exemptions

• In addition to fitting into either the qualifying
  child or the qualifying relative category, a
  dependent must also meet
• The joint return, and
• The citizenship or residency tests

28
Joint Return Test

• Dependent cannot file a joint return with spouse
  unless
• Filing solely for refund of tax withheld
• No tax liability exists for either spouse
• Neither spouse required to file return

29
Citizen or Residency Test

• Dependent must be a U.S. citizen or a resident of
  U.S., Canada, or Mexico

30
Personal and Dependency Exemptions In Year Of
Death

• Personal exemption allowed on joint return for
  spouse who dies during the year
• Example Tom and Betty were married in 1990. Tom
  dies on February 1, 2007. A personal exemption
  may be claimed for Tom on the taxpayers 2007
  joint return.

31
Phase-out of Exemptions (slide 1 of 2)

• Applies when taxpayers AGI in 2007 exceeds
• 234,600 for married, filing jointly, or
  surviving spouse
• 195,500 for head of household
• 156,400 for single
• 117,300 for married, filing separately
• The phase-out of exemptions is being repealed in
  two stages and will not be complete until 2010
• The exemption phaseout remains at two-thirds for
  2006 and 2007 and at one-third for 2008 and 2009

32
Phase-out of Exemptions (slide 2 of 2)

• Exemptions deduction is reduced by 2 for every
  2,500 (1,250 for MFS), or part thereof, that
  AGI exceeds threshold amounts
• The amount of the phased-out exemptions is then
  multiplied by 2/3 (the reduction-of-phaseout
  fraction) for tax years 2006 and 2007

33
Child Tax Credit

• 1,000 tax credit is allowed for each dependent
  child under the age of 17
• Qualifying child includes stepchildren and
  eligible foster children

34
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, and other amounts
• Marital status determined on the last day of the
  tax year
• Separated spouses are considered married until
  divorce becomes final

35
Single Filing Status

• Includes a taxpayer who is unmarried or separated
  from spouse by a divorce decree or separate
  maintenance agreement and does not qualify for
  another filing status
• Marital status is determined as of the last day
  of the tax year
• When a spouse dies during the year, marital
  status is determined as of the date of death

36
Married Filing Jointly (MFJ) Filing Status

• Married as of last day of taxable year, or
• Spouse dies during taxable year

37
Surviving Spouse Filing Status

• Same tax rate brackets as married, filing jointly
• File as surviving spouse for 2 years after death
  of spouse if taxpayer maintains a home in which a
  dependent child lives

38
Married Filing Separately Filing Status

• Married but not filing a return with spouse and
  not abandoned spouse
• If one spouse itemizes, the other spouse must
  also itemize. Why?

39
Should a couple file married filing joint or
married filing separately?

• If both have income, and one has significant
  amounts of medical expenses, miscellaneous
  itemized deductions or casualty losses, may want
  to file separately.
• Certain benefits available only if file joint
  return.
• If file jointly, usually both are liable for the
  tax
• Common Law marriages are acceptable.

40
Filing Status Unmarried

• Unmarried taxpayers file as
• Single
• Head of household - an unmarried person who
  provides more than half of the cost of
  maintaining a home in which a qualifying child or
  other qualifying relative lives for more than
  half the year

41
Head of Household (HH) Filing Status

• Must be unmarried as of end of year or an
  abandoned spouse
• Must pay gt half the cost of maintaining a
  household which is the principal home of a
  dependent for more than half of tax year
• For tax years after 2004, a dependent must
  satisfy either the qualifying child or the
  qualifying relative category
• A qualifying relative must also meet the
  relationship test

42
Exception to the HH Requirements

• HH may be claimed if taxpayer maintains a
  separate home for his or her parents
• At least one parent must qualify as a dependent

43
Abandoned Spouse

• Allows married taxpayer to file as Head of
  Household if taxpayer
• Does not file a joint return
• Paid gt half the cost of maintaining a home
• Spouse did not live in home during last 6 months
  of tax year
• Home was principal residence of taxpayers child
  for gt half of year
• Can claim child as a dependent

44
Standard Deduction (slide 1 of 2)

• The basic standard deduction (BSD) amount depends
  on filing status of taxpayer

Filing status 2006 2007 . Single
5,150 5,350 MFJ, SS 10,300 10,700 HH
7,550 7,850 MFS 5,150 5,350
45
Standard Deduction(slide 2 of 2)

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

Filing Status 2006 2007 . Single
1,250 1,300 MFJ, SS 1,000 1,050 HH
1,250 1,300 MFS 1,000 1,050

46
65 or older

• Must be 65 by last day of the year
• Taxpayer is treated as though s/he is 65 the day
  before his/her birthday.

47
Determining Standard Deduction

• Examples (2007 tax year)
• Taxpayer is single, blind, and age 65 or older
• SD 5,350 (BSD) 1,300 (ASD) 1,300 (ASD)
  7,950
• Taxpayers are married, filing jointly, one blind,
  and both age 65 or older
• SD 10,700 (BSD) 1,050 (ASD) 1,050 (ASD)
  1,050 (ASD) 13,850

48
Taxpayers Ineligible for Standard Deduction

• Certain taxpayers cannot use the SD
• Married, filing separately, when either spouse
  itemizes deductions
• Nonresident aliens
• Individual filing return for tax year of less
  than 12 months because of change in annual
  accounting period

49
FILING LEVELS

• Determines who must file a return.
• Varies with Filing Status
• Generally the amount SD minimum amount of
  personal exemptions to which everyone with that
  Filing Status would be entitled.

50
FILING LEVEL - EXCEPTIONS

• Do not add an additional amount to the standard
  deduction for being blind.
• If married filing separately, do not add in the
  SD.
• Must file if self-employment income 400.
• For HH or Surviving Spouse, assume only one
  personal exemption amount.

51
Example

• MFJ 2007
• 2 P.E. 6,800
• SD 10,700
• 17,500
• Both 65 2,100
• Both blind 0
• ______
• 19,600
  

52
PROBLEM

• Husband and wife file a joint return, he is 72,
  she is 70, and both are blind. Their Gross
  Income for the year is 20,000.
• What is their SD?
• Do they have to file a return?
• Will they owe any tax?

53
PROBLEM

• A 69 year old widow maintains a household for her
  35 year old disabled daughter. She provides gt
  50 of the daughters support. The daughter has
  no taxable income. The widow has Gross Income of
  13,000.
• What is the widows SD?
• Does she have to file a return?
• Will she owe any tax?

54
SPECIAL RULES FOR DEPENDENTS RETURNS
55
If a taxpayer can be claimed as a dependent by
someone else, that taxpayer can not deduct an
amount for the personal exemption on his/her own
return.
56
SD Limit For Person Claimed as Dependent

• Individual claimed as dependent has a BSD limited
  to the greater of
• 850 or
• 300 plus earned income (but not exceeding
  normal BSD)
• ASD amount(s) still available

57
Examples of SD Limit (slide 1 of 2)

• Dependents SD (2007 tax year)
• A blind child who earns 200 and is claimed by
  parents as a dependency exemption
• SD 850 (BSD) 1,300 (ASD) 2,150
• A child who earns 1,500 and is claimed by
  parents as a dependency exemption
• SD 1,800 BSD equal to greater of 850 or
  (300 1,500 earned income)

58
Examples of SD Limit (slide 2 of 2)

• Examples of dependents SD (2007 tax year)
• A child who earns 5,500 and is claimed by
  parents as a dependency exemption
• SD 5,350 BSD limited to normal amount

59
Kiddie Tax (slide 1 of 4)

• Net unearned income (NUI) of child is taxed at
  parents rate
• Child must be under age 18 at end of year
• NUI generally equals unearned income less 1,700
  (2007 tax year)

60
Kiddie Tax (slide 2 of 4)

• Unearned income includes
• Taxable interest
• Dividends
• Capital gains
• Rents
• Royalties
• Pension and annuity income, and
• Unearned income from trusts

61
Kiddie Tax (slide 3 of 4)

• Computing NUI for Kiddie Tax
• Unearned income
• Less The greater of
• i) 850, or
• ii) Allowable itemized deductions connected
  with production of unearned income
• Less 850 (1st 850)
• Equals net unearned income

62
Kiddie Tax (slide 4 of 4)

• Net unearned income taxed at parents rate
• Remainder of taxable income taxed at childs rate
• Two options for computing the tax
• A separate return may be filed for the child
• The tax on net unearned income (referred to as
  the allocable parental tax) is computed as though
  the income had been included on the parents
  return
• Form 8615 is used to compute the tax
• The parents may elect to report childs income on
  their own return
• Certain requirements must be met

63
PROBLEMS

• Tom is 8 years old, and is claimed as a dependent
  on his parents return. He has 1200 of unearned
  income and no earned income. What is his NUI?
• Tom is 8 years old, and is claimed as a dependent
  on his parents return. He has 2000 of unearned
  income and no earned income. What is his NUI?

64
PROBLEMS

• Gene is 12 years old and is claimed as a
  dependent on his parents return. He had
• 1,000 earned income
• 2500 unearned income
• 900 itemized deductions directly connected with
  the production of the unearned income
• 400 other itemized deductions
• What is his TAXABLE INCOME, and at whos rate is
  it taxed?

65
PROBLEMS

• Nancy is 10 years old and is claimed as a
  dependent on her parents return. She had
• 400 earned income
• 2000 unearned income
• 1,000 in total itemized deductions
• 200 of which were directly connected with the
  production of the unearned income
• What is her TAXABLE INCOME, and at whos rate is
  it taxed?

66
Taxes Rates

• Prior to recent legislation, tax rates were 15,
  28, 31, 36, and 39.6
• Effective January 1, 2003
• Tax rates are 10, 15, 25, 28, 33, and 35

67
Filing Requirements

• Tax return of an individual is due on or before
  the 15th day of the 4th month after taxpayers
  year end
• Most individuals are calendar year taxpayers,
  thus, due date is April 15
• May obtain a 6 month extension of time to file
• Excuses a taxpayer from penalty for failure to
  file, not from penalty for failure to pay
• If more tax is owed, extension request (Form
  4868) should be accompanied by check for balance
  of tax due

68
STATUTE OF LIMITATIONS

• IRS must assess addl tax liability w/in 3 years
  of later of date return was filed or due date of
  return.
• If taxpayer omits income gt25 of gross income
  reported, statute of limitations is increased to
  6 years.
• There is no statute of limitations if no return
  is filed or if a fraudulent return is filed.

69
Individual Taxpayers may file tax form

• 1040
• 1040A
• 1040EZ

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You can use Form 1040EZ if all of the following
apply.  

• Your filing status is single or married filing
  jointly. If you were a nonresident alien at any
  time in 2007, your filing status must be married
  filing jointly.
• You (and your spouse if married filing a joint
  return) were under age 65 and not blind at the
  end of 2007. If you were born on January 1, 1943,
  you are considered to be age 65 at the end of
  2007.
• You do not claim any dependents.
• Your taxable income is less than 100,000.
• Your income is only from wages, salaries, tips,
  unemployment compensation, Alaska Permanent Fund
  dividends, taxable scholarship and fellowship
  grants, and taxable interest of 1,500 or less.
• You did not receive any advance earned income
  credit (EIC) payments.
• You do not claim any adjustments to income, such
  as a deduction for IRA contributions or student
  loan interest.
• You do not claim any credits other than the
  earned income credit.
• You do not owe any household employment taxes on
  wages you paid to a household employee.

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You can use Form 1040A if all of the following
apply.   

• Your income is only from wages, salaries, tips,
  IRA distributions, pensions and annuities,
  taxable social security and railroad retirement
  benefits, taxable scholarship and fellowship
  grants, interest, ordinary dividends (including
  Alaska Permanent Fund dividends), capital gain
  distributions, and unemployment compensation.
• Your taxable income is less than 100,000.
• Your adjustments to income are for only the
  following items.
• Educator expenses.
• IRA deduction.
• Student loan interest deduction.
• Tuition and fees deduction.
• You do not itemize your deductions.
• Your taxes are from only the following items.
• Tax Table.
• Alternative minimum tax. (See chapter 30.)
• Advance earned income credit (EIC) payments, if
  you received any. (See chapter 36.)
• Recapture of an education credit. (See chapter
  35.)
• Form 8615, Tax for Children Under Age 18 With
  Investment Income of More Than 1,700.
• Qualified Dividends and Capital Gain Tax
  Worksheet.

75
You can use Form 1040A if all of the following
apply. (Contd)

• You claim only the following tax credits.
• The credit for child and dependent care expenses.
  (See chapter 32.)
• The credit for the elderly or the disabled. (See
  chapter 33.)
• The child tax credit. (See chapter 34.)
• The additional child tax credit. (See chapter
  34.)
• The education credits. (See chapter 35.)
• The retirement savings contributions credit. (See
  chapter 37.)
• The earned income credit. (See chapter 36.)
• You did not have an alternative minimum tax
  adjustment on stock you acquired from the
  exercise of an incentive stock option. (See
  Publication 525, Taxable and Nontaxable Income.)

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You must use Form 1040 if any of the following
apply.

• Your taxable income is 100,000 or more.
• You itemize your deductions.
• You had income that cannot be reported on Form
  1040EZ or Form 1040A, including tax-exempt
  interest from private activity bonds issued after
  August 7, 1986.
• You claim any adjustments to gross income other
  than the adjustments listed earlier under Form
  1040A.
• Your Form W-2, box 12, shows uncollected employee
  tax (social security and Medicare tax) on tips
  (see chapter 6) or group-term life insurance (see
  chapter 5).
• You received 20 or more in tips in any 1 month
  and did not report all of them to your employer.
  (See chapter 6.)
• You were a bona fide resident of Puerto Rico and
  exclude income from sources in Puerto Rico.
• You claim any credits other than the credits
  listed earlier under Form 1040A.
• You owe the excise tax on insider stock
  compensation from an expatriated corporation.
• Your Form W-2 shows an amount in box 12 with a
  code Z.
• You had a qualified health savings account
  funding distribution from your IRA.
• You are an employee and your employer did not
  withhold social security and Medicare tax.
• You have to file other forms with your return to
  report certain exclusions, taxes, or
  transactions.
• You are a debtor in a bankruptcy case filed after
  October 16, 2005.