Income Taxation of Individuals

1
Income TaxationofIndividuals

• Chapter 11

2
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

3
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

4
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

5
Deductions For AGI

• Deductions discussed in this chapter
• Educator expenses (expired 2005)
• Student loan interest expense
• Tuition and fees deduction (expired 2005)
• Health savings accounts
• Penalty on early withdrawals of savings
• Other deductions for AGI

6
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 2005 but bill is pending in
  Congress that may extend it retroactively

7
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 (105,000 - 135,000 for married persons
  filing jointly)
• Individuals claimed as dependents cannot take
  deduction on their own tax return
• Eligible expenses must be reduced for tax-exempt
  scholarships and education credits

8
Tuition Fees Deduction

• 4,000 deduction for 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)

9
Health Savings Accounts

• Taxpayers covered by high-deductible medical
  insurance policies only may deduct amounts set
  aside in an HSA
• Contributions and earnings on HSAs are not taxed
  when withdrawn to pay medical expenses
• Distributions not spent on qualifying expenses
  are included in income and subject to a 10
  penalty

10
Health Savings Accounts

• To qualify for an HSA in 2006, individuals must
  have health insurance with deductibles of at
  least 1,050 (2,100 for families)
• Maximum contribution to HSA equal to lesser of
  2,700 (5,450 for families) or the annual policy
  deductible

11
Medical Savings Accounts

• MSAs are similar to HSAs but with different
  limits
• Qualified policies are those with deductibles of
  1,800 - 2,700 for individuals (3,650 - 5,450
  for families) in 2006
• Contributions to MSAs are limited to 65 of
  policy deductible for individuals (75 for
  families)
• Distributions not spent on qualifying expenses
  are included in income and subject to a 15
  penalty

12
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

13
Other Deductions For AGI

• Unreimbursed 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
• Expenses of fee-basis government officials
• Expenses of performing artists

14
Exemptions

• Each taxpayer (who is not a dependent) is
  entitled to one personal exemption
• Exemption deduction is 3,300 for 2006
• Additional exemptions allowed for each person who
  is considered a dependent
• Anyone who is claimed as a dependent cannot claim
  a personal exemption
• For purposes of the dependency exemption, a
  dependent is a qualifying child or qualifying
  relative

15
Qualifying Child

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

16
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 (3,300 for 2006)
• Support test

17
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

18
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 more than 10 support agree to exemption

19
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 for 2006 of
• 150,500 if single
• 188,150 if head of household
• 225,750 if married filing jointly
• 112,875 if married filing separately

20
Exemption Phaseout

• (AGI threshold AGI)/2,500 Phaseout Factor
  (always round up to next whole number)
• Phaseout Factor x 2 Phaseout Percentage
• Phaseout Percentage x Exemption Amount x 2/3
  Exemption Reduction
• Exemption Amount Exemption Reduction
  Allowable Exemption Deduction
• Once AGI exceeds the threshold AGI by more than
  122,500 (61,250 for MFS), only 1/3 of
  exemption deduction remains

21
Filing Status

• Taxpayers 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

22
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 files separately, both must itemize
  deductions or both must use the standard deduction

23
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

24
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 qualifying child or
  other qualifying relative lives for more than
  half the year
• Single

25
Head of Household

• Claimed if taxpayer is unmarried (and not a
  surviving spouse)
• Taxpayer pays more than half the cost of
  maintaining home which is the principal residence
  for more than half the year of
• A qualifying child
• An individual for whom the taxpayer may claim a
  dependency exemption
• A parent is not required to live with the taxpayer

26
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

27
Standard Deductions

• Standard Deductions
• 10,300 married filing a joint return
• 5,150 married filing separately
• 7,550 head of household
• 5,150 single individual
• Additional standard deduction if taxpayer is
  elderly (age 65 or older) or blind
• 1,250 if single or head of household
• 1,000 if married

28
Dependents Standard Deduction

• Dependents standard deduction is limited to the
  greater of
• 850 or
• Earned income 300 (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

29
Itemized Deductions

• Itemized deductions provide tax benefit only to
  the extent that, in total, they exceed the
  taxpayers standard deduction
• Taxpayers can maximize use of the standard
  deduction and itemized deductions by timing
  certain deductible payments

30
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

31
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

32
Deductible Taxes

• 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
• For 2005 could elect to deduct state local
  general sales taxes instead of state local
  income taxes

33
Nondeductible Taxes

• Nondeductible taxes include
• Federal income taxes
• Employee's share of payroll taxes
• Federal excise taxes not incurred for business
• Assessments on property that increase property
  value

34
Interest Expense

• Deductible interest includes
• Investment interest
• Home mortgage interest
• No deduction for most other personal interest
  (except previously mentioned student loan
  interest) including interest on
• Auto loans
• Life insurance loans
• Credit card debt
• Delinquent tax payments

35
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

36
Investment Interest Expense

• Investment income includes gross 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 include 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

37
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

38
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

39
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

40
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 not
  deductible

41
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 deduction limited to 50 of AGI
• Excess contributions may be carried forward up to
  5 years

42
Charitable Contributions

• No deduction for contributions of the taxpayers
  services and rent-free use of the taxpayers
  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

43
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 adjusted basis, if lower than FMV
• Deduction for LTCG property 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

44
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
• Deduction for donated vehicles sold by charity
  limited to gross sales proceeds

45
Casualty and Theft Losses

• Loss is the lesser of
• Assets adjusted basis or
• Decline in assets 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

46
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

47
Phaseout ofItemized Deductions

• Total deductions phased out by 2/3 x 3 of AGI in
  excess of 150,500 in 2006 (75,250 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
  x 2/3 regardless of type

48
Tax Rates forMarried Filing a Joint Return

• For married filing a joint return for 2006
• 10 on first 15,100 taxable income
• 15 on 15,101 - 61,300
• 25 on 61,301 - 123,700
• 28 on 123,701 - 188,450
• 33 on 188,451 - 336,550
• 35 over 336,550

49
Tax Rates forMarried Filing Separately

• For married filing separately for 2006
• 10 on first 7,550 taxable income
• 15 on 7,551 - 30,650
• 25 on 30,651 - 61,850
• 28 on 61,851 - 94,225
• 33 on 94,226 - 168,275
• 35 over 168,275

50
Tax Rates forHead of Household

• For head of household for 2006
• 10 on first 10,750 taxable income
• 15 on 10,751 - 41,050
• 25 on 41,051 - 106,000
• 28 on 106,001 - 171,650
• 33 on 171,651 - 336,550
• 35 over 336,550

51
Tax Rates for Single Individuals

• For single individuals for 2006
• 10 on first 7,550 taxable income
• 15 on 7,551 - 30,650
• 25 on 30,651 - 74,200
• 28 on 74,201 - 154,800
• 33 on 154,801 - 336,550
• 35 over 336,550

52
Special Tax Rates

• Dividend income is taxed at a maximum of 15 (5
  for taxpayers in 10 or 15 tax brackets)
• Individuals with long-term capital gains file a
  Schedule D which includes a worksheet for
  determining the total tax liability

53
Credits vs. Deductions

• Deductions only reduce tax liability by a
  percentage based on the taxpayers 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

54
Child Tax Credit

• 1,000 nonrefundable tax credit for each
  qualifying child under age 17
• Qualifying children include the taxpayers 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

55
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 1,100
  and 50 of second 1,100 tuition and fees for
  first 2 years only (maximum 1,650 per student)
• Lifetime Learning Credit 20 of up to 10,000
  tuition and fees (maximum 2,000 per taxpayer)
• A student who is a dependent cannot claim the
  credit

56
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
• 45,000 - 55,000 if single
• 90,000 - 110,000 if married filing jointly

57
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
  2,747 (8,080 x 34) for 2006
• With two or more qualifying children, maximum
  credit is 4,536 (11,340 x 40)
• Smaller credit available to taxpayers without
  children

58
Earned Income Credit

• This is a refundable credit
• Taxpayers with investment income of 2,800 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 and 64 to be eligible
• Credit starts phasing out when income exceeds
  16,810 if married filing jointly (14,810 for
  others)

59
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

60
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

61
Excess Payroll Tax Credit

• Taxpayers working for more than one employer
  during the year with earnings exceeding the
  Social Security ceiling (94,200 for 2006)
  usually have too much tax withheld
• Employee is allowed a refundable credit for any
  excess Social Security taxes withheld

62
Credits for Energy Efficiency

• 10 for insulation, windows, skylights, exterior
  doors metal roofs for improvements to principal
  residence (500 maximum credit)
• 30 for qualified solar water heating equipment
  (2,000 maximum) and equipment that uses solar
  power to generate electricity (2,000 maximum)
  for improvements to principal residence or
  vacation home
• Up to 3,400 credit for hybrid vehicles

63
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
  years tax), a penalty may be charged, unless
  balance due is less than 1,000

64
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
• 8,450 in 2006 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 850
• Any married person filing separately has income
  over 3,300

65
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

66
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

67
AMT Exemptions

• AMT exemptions for 2006 are
• 62,550 if married filing jointly
• 31,275 if married filing separately
• 42,500 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

68
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

69
The End