CHAPTER 1The Individual

Income Tax Return

Income Tax Fundamentals 2012

Gerald E. WhittenburgMartha Altus-Buller

2012 Cengage Learning 1

Learning Objectives

� Understand history/objectives of U.S. tax law� Describe different entities subject to tax/reporting requirements

� Understand and apply tax formula� Identify who must file tax returns � Determine filing status & understand calculation of tax according to filing status

� Calculate number of exemptions and exemption amounts� Calculate correct standard or itemized deduction amount for taxpayers

� Compute basic capital gains and losses� Access and use various internet tax resources� Understand the basics of e-filing

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History of Taxation

�Since 1913, when 16th amendment was passed, the constitutionality of income tax has never been questioned

� Income taxes serve a multitude of purposes

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Objectives of Tax Law

� Raise revenue

� Tool for social and economic policies

◦ Social policy encourages desirable activities and discourages undesirable activities

� Credits for investment in solar and wind energy

� Can deduct charitable contributions

� Credits for higher education expenses

◦ Economic policy as manifested by fiscal policy

� Encourage investment in capital assets through depreciation

◦ Both economic and social

� Exclude gain on sale of personal residence up to $250,000 ($500,000 if married)

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Primary Entities/Forms

� Individual◦ Taxable income includes wages, salary, self-employment earnings, rent, interest and dividends

◦ An individual may file simplest tax form qualified for

� 1040EZ

� 1040A

� 1040

◦ If error made on one of the three above forms, can amend with a 1040X

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See next slide

Primary Entities/Forms

� Individual

◦ 1040EZ

� Single or Married Filing Jointly (MFJ)

� Must not be 65 or older and/or blind

� Must not claim any dependents

� Taxable income must be under $100,000

� Only wages, salaries or unemployment and not more than $1,500 taxable interest income

� Not claim any credits other than the earned income credit

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Primary Entities/Forms� Individual (continued)

◦ 1040A� Generally used by taxpayers who are not self-employed and don’t itemize deductions

◦ 1040

� If taxpayer doesn’t qualify to use 1040EZ or 1040A,should complete a 1040 with possible schedules attached◦ Schedule A to itemize deductions◦ Schedule B to report dividends/interest income > $1500◦ Schedule C to report trade/business income◦ Schedule D to report capital gains/losses◦ Schedule E to report rental/royalty income◦ Schedule F to report farm/ranch activities

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Primary Entities/Forms

�Corporations

◦ Tax rate schedule found on page 1-4◦ Corporations need to file 1120 or 1120S◦ 1120S is for corporations that elect S Corporation status

� Don’t pay regular corporate income taxes� Instead, pass through items of income or loss to shareholders

�Partnerships◦ Reporting entity, not taxable entity◦ 1065 – reports income/loss and allocation to partners

� Pass through items of income or loss to partners

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Tax Formula for Individuals

This formula follows Form 1040

Gross Income

less: Deductions for Adjusted Gross Income (AGI)

AGI

less: Greater of Itemized or Standard Deduction

less: Exemption(s)

Taxable Income

times: Tax Rate (using tax tables or rate schedules)

Gross Tax Liability

less: Tax Credits and Prepayments

Tax Due or Refund

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Standard Deduction & Exemptions

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2011 standard deduction ($)

Single 5,800

Married Filing Joint (MFJ) 11,600Qualifying Widow(er) 11,600also known as Surviving Spouse (SS)

Head of Household (HOH) 8,500

Married Filing Separate (MFS) 5,800

*Taxpayers 65 or older and/or blind get an additional amount$1,150 if MFJ, MFS or SS$1,450 if HOH or Single

2011 exemption $3,700 – personal & dependency

Using Tax Formula

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Facts: Juan (age 29) is a single taxpayer. In 2011, his salary is $39,000 and he has dividend income of $1000. In addition, he has deductions for AGI of $2,500 and $3,000 of itemized deductions. If Juan claims one exemption for this year, calculate the following amounts:

Gross income ___________

Deductions for AGI ___________

Adjusted gross income ___________

Greater of the standarddeduction or itemized deductions ___________

Exemptions ___________

Taxable income ___________

Solution

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Gross income $40,000

Adjusted gross income ___________

Greater of the standarddeduction or itemized deductions ___________

Exemptions ___________

Taxable income ___________

Gross income = $39,000 + 1,000

Solution

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Gross income $40,000

Adjusted gross income 37,500

Greater of the standarddeduction or itemized deductions ___________

Exemptions ___________

Taxable income ___________

AGI = $40,000 – 2,500

Solution

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Gross income $40,000

Adjusted gross income 37,500

Greater of the standarddeduction or itemized deductions 5,800

Exemptions

Taxable income ___________

The standard deduction of $5,800 exceeds itemized deductions of $3,000

Solution

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Gross income $40,000

Adjusted gross income 37,500

Greater of the standarddeduction or itemized deductions 5,800

Exemptions 3,700

Taxable income $28,000

Who Must File

� Based on filing status and gross income

◦ Generally, if exemptions

plus

greater of standard or itemized deductions exceed income, then filing is not necessary

◦ If taxpayer is claimed as a dependent on another taxpayer’s return, dependent’s standard deduction is:� Greater of $950

or� Earned income + $300 � But never more than standard deduction

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See Figures 1.1

and 1.2 on page 1-8

Who Must File

�Taxpayer must file if◦ Owe any special taxes

� See Figure 1.3 on page 1-9

◦ Had self-employment income >= $400

◦ Other special situations as outlined on Chart C

(Figure 1.3)

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Which Taxpayers are Required to File

Note: Must analyze each independent situation to determine if the taxpayer is required to file a return for 2011

Miles (age 45) is a single waiter and has unreported tips of $1,510; is he required to file?

Yes, because Miles owes social security taxes on unreported tips.

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Which Taxpayers are Required to File

Simone is single (age 31) and blind and has income of $10,370; is she required to file?

No, because standard deduction = $7,250 ($5,800 + 1,450); exemption= $3,700. These amounts total to $10,950 and exceed her gross income.

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Which Taxpayers are Required to File

Eamon (age 67) and his wife, Roisin, (age 69) have income of $19,180 and file jointly; are they required to file?

No, because standard deduction = $13,900 ($11,600 + 1,150 + 1,150); exemptions = $7,400. These amounts total to $21,300 and exceed their gross income.

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Which Taxpayers are Required to File

Taig is a single full time college student, age 21, with wages from a part-time job of $7,340. He is claimed as a dependent by his parents; is he required to file?

Yes, because Tai’s standard deduction = $5,800 and his income exceeds this amount. His exemption is 0 as he’s claimed by parents.

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Filing Status� Single

◦ Unmarried or legally separated as of 12/31

◦ And not qualified as married filing separately, head of household or qualifying widow(er)

� Married Filing Jointly (MFJ)

◦ If married on 12/31 – even if didn’t live together entire year

◦ Same-sex couples may not file jointly

◦ If spouse dies during year you can file MFJ in current year

� Married Filing Separately (MFS)

◦ Each file separate returns

◦ Must compute taxes the same way - both itemize or both use standard

◦ If living in community property state, must follow state law

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Filing Status

� Head of Household (HOH)

◦ Tables have lower rates than single or MFS

◦ Taxpayer can file as HOH if:

� Unmarried or abandoned* as of 12/31

� Paid > 50% of cost of keeping up home that was principal

residence of dependent child or other qualifying dependent

relative

� There is one exception to principal residence requirement. If

dependent is taxpayer’s parent, he/she doesn’t have to live with

taxpayer.

Note: A divorced parent who meets above rules and has signed IRS/legal document,

may still claim HOH even if dependency exemption shifted to ex-spouse

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*See pages 1-10 and 1-11 for requirement for abandoned spouse

Filing Status

�Qualifying Widow(er) with Dependent Child

◦ Also known as surviving spouse

◦ Available for two subsequent years after death of spouse

� Must pay over half the cost of maintaining a household where a dependent child, stepchild, adopted child or foster child lives

◦ Gets benefits of married filing joint tax rates

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Tax Computation

�Six brackets (in Appendix)◦ 10%, 15%, 25%, 28%, 33%, 35%

◦ Tax rate schedules for different filing types

�Qualifying dividends and net long-term capital gains may be taxed at lower rates◦ Rates based on ordinary tax bracket

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Personal/Dependency Exemptions

�Personal exemptions may be taken for self and spouse

�Additional exemptions may be taken for individuals who are either taxpayer’s◦ Qualifying child

or

◦ Qualifying relative

�For 2011 each exemption = $3,700

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Dependency – Qualifying Child

Dependency exemption allowed when six tests met� Relationship Test - child is taxpayer’s child, stepchild,

adopted child or taxpayer’s sibling, half- or step-sibling, or a descendant of any of these. Foster child may also qualify. Child must be younger than person claiming him/her, unless permanently disabled.

� Domicile Test- child has same principal place of abode as taxpayer for more than ½ the year.

� Age Test – child is under 19 or a full-time student under 24 (enrolled at least 5 months of year).

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Dependency – Qualifying Child

� Joint Return Test – child doesn’t file joint return with spouse (exception: if it’s only to claim refund, then considered to have passed this test).

� Citizenship Test – child is a US citizen, a resident of the US, Canada or Mexico, or an alien child adopted by and living with a US citizen.

� Self-Support Test – child who provides more than ½ of his/her own support cannot be claimed as a dependent of someone else. Funds received by students as scholarships are excluded from support test.

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What if Child Meets Dependency Requirements for More than One Taxpayer?

� If one of the parties is a parent, he/she can claim

� If both parties are a parent, then one with whom the child resides longest can claim

o If not ascertainable, parent with highest AGI may claim

� If no parents are involved, person with highest AGI may claim

Note: If parents are legally separated/divorced, person with whom child resides more than 6 months may claim.

� Exemption can shift if custodial parent signs Form 8332 and form is attached to noncustodial parent’s tax return

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Dependency – Qualifying Relative

Dependency exemption may be granted for a qualifying relative (who is not a qualifying child) based on tests on next slide.

Note: A taxpayer’s child who does not meet qualifying child test may meet qualifying relative test!!

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Dependency – Qualifying Relative

� Relationship or Member of Household Test – list of relatives that qualify is available at IRS web site� Note: A member of household (even if unrelated) for entire year meets the relationship test

� Gross Income Test – individual may not have gross income in excess of $3,700

� Support Test – dependent must receive over ½ of his/her support from taxpayer

� Joint Return Test – dependent may not file a joint return unless it’s solely to claim refund

� Citizenship Test – dependent must meet the citizenship test identified in the qualifying child slide

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Standard Deduction

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2011 standard deduction

Single $ 5,800

Married Filing Joint (MFJ) $11,600Qualifying Widow(er) $11,600also known as Surviving Spouse

Head of Household (HOH) $ 8,500

Married Filing Separate (MFS) $ 5,800

*Plus additional amounts for blindness or over 65: $1,150 if MFJ, MFS or qualifying widow(er) and $1,450 if HOH or Single

Standard Deduction - Dependents

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The special rule for standard deduction for dependents is “Deduction = Greater of $950 or earned income + $300, but only up to basic standard deduction”

Example 1: Jaime is 23 and a full time student and her parentsclaim her as a dependent; she earned $2,000 in 2011, how much is taxable income?

$2,000 earned income(2,000) standard deduction$0 taxable income

Example 2: Tia is 18 - has dividend income of $1,500 (dividends are considered unearned income), how much is taxable income?

$1,500 dividend income( 950) standard deduction$ 550 taxable income

Basic Gain & Loss Model

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Amount Realized*

- Adjusted Basis**

Realized Gain/Loss* Sales Price - Sales Expenses

** Cost - Accumulated Depreciation

Note: Most realized gains/losses are also

recognized (i.e. – included in taxpayer’s income)

Capital Gains/Losses

� A capital asset is any property (personal or investment) held by a taxpayer, with certain exceptions as listed in the tax law ◦ Examples: stocks, bonds, land, cars and other items held for investment

◦ Gains/losses on these assets are subject to special rates

� Holding period of asset determines treatment ◦ Long-term is held >12 months (taxed at capital rates – see next screen)

◦ Short-term is held <= 12 months (taxed at ordinary rates)

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Capital Gains/Losses

� Long term capital gain

◦ Special rates depending upon taxpayer’s bracket

Ordinary Tax Bracket Capital Gains Tax Rate

10% or 15% 0%

All other brackets 15%

� Long term capital loss

◦ Only allowed $3,000 net capital loss per year against ordinary income

◦ Carry-forward any unused balance

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Calculating Gain/Loss

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Facts: Noah purchased Sony AAA bonds in 2006 for $47,600. In 2011, he sold the bonds for $51,500, paying commission of $515. What is his:

Amount realized ___________

Adjusted basis ___________

Realized gain/loss ___________

Recognized gain/loss ___________

Type of gain/loss ___________

Solution

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Amount realized * $50,985

Adjusted basis 47,600

Realized gain/loss 3,385

Recognized gain/loss 3,385

Type of gain/loss Long term capital gain

*Amount realized = $51,500 – 515

Tax and The Internet

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�Volumes of tax information available on interneto http://www.irs.gov contains forms and publications and a search engine to aid the user in obtaining useful information

� The IRS has also launched a YouTube video site and an iTunes podcast site featuring topics like how to obtain refund or file an extension

� Other good sites include www.hrblock.com and www.willyancey.com

� In some states, names of delinquent taxpayers posted on web sites

Electronic Filing

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�Rules in constant transition, as IRS attempts to transition all taxpayers to e-filing

�Taxpayers may prepare electronic returns using own PC and tax preparation software

or� May utilize a paid preparer who employs e-filing

The End!

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