Income Tax Fundamentals 2010 edition Gerald E. Whittenburg

Martha Altus-Buller

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Since 1913 - adoption of 16th amendment - the constitutionality of income tax has never been questioned

Income taxes serve a multitude of purposes

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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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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

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 received advance earned income credit

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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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Corporations◦ Tax rate schedule found on page 1-3◦ 1120 or◦ 1120S - 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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This formula follows Form 1040

Gross Income

less: Deductions for Adjusted Gross Income (AGI)

AGI

less: Greater of Itemized or Standard Deduction

less: Exemptions

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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2009 standard deductionSingle $ 5,700

Married Filing Joint (MFJ) $11,400Qualifying Widow(er) $11,400 also known as Surviving Spouse

Head of Household (HOH) $ 8,350

Married Filing Separate (MFS) $ 5,700

*Taxpayers 65 or older and/or blind get an additional amount$1,100 if MFJ, MFS or SS$1,400 if HOH or Single

2009 exemption $3,650 – personal & dependency

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Facts: Juan (age 29) is a single taxpayer. In 2009, 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 ___________

Adjusted gross income ___________

Greater of the standard deduction or itemized deductions ___________

Taxable income ___________

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’s return, dependent’s standard deduction is: Greater of $950

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

See Figures 1 and 2 on pages 1-7 and 1-8

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Taxpayer must file if

◦ Owe any special taxes (See Figure 3 on page 1-8)

◦ Received Advanced Earned Income Credit payments from employer

◦ Had self-employment (SE) income >= $400

◦ Other situations outlined on Chart C

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Note: Must analyze each independent situation to determine if the taxpayers are required to file a return for 2009

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

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

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Taxpayer is single (age 31) and blind and has income of $9,950; is the taxpayer required to file?

No, because standard deduction = $7,100 ($5,700 + 1,400); exemption= $3,650. These amounts total to $10,750 and exceed income.

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Husband (age 67) and wife (age 69) have income of $19,180 and MFJ; are the taxpayers required to file?

No, because standard deduction = $13,700 ($11,400 + 1,100 + 1,100); exemptions = $7,300. These amounts total to $20,900 and exceed income.

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Taxpayer is a single full time college student, age 21, with wages from a part-time job of $6,340. He is claimed as a dependent by his parents; is the taxpayer required to file?

Yes, because standard deduction = $5,700; exemption = 0 (as he’s claimed by parents). Income exceeds these amounts.

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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 to determine community and separate income

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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 p. 1-10 for requirement for abandoned spouse

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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Six brackets (in Appendix)◦ 10%, 15%, 25%, 28%, 33%, 35%◦ Tax rate schedules for different filing types◦ Marginal rate may exceed 35% when taxpayers are

required to phase-out exemptions and deductions Qualifying dividends and net long-term

capital gains may be taxed at lower rates◦ Rates based on ordinary tax bracket

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Provisions includes Making Work Pay Credit◦ $400 ($800 MFJ) refundable credit on 2009 tax return

Reduced by any automatic rebate received by certain taxpayers in 2009

Reflected in new FIT withholding tables which directly infused cash into economy through increased wages

Phases-out $75,000 ($150,000 MFJ) Complete Schedule M to calculate credit

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Personal exemptions may be taken for self/spouse

Additional exemptions may be taken for individuals who are either ◦ Qualifying child

or

◦ Qualifying relative

For 2009 each exemption = $3,650 Exemption phased-out to $2,433 when AGI

exceeds certain AGI thresholds

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Dependency exemption allowed for child when six tests metRelationship 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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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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Dependency exemption may be granted for a qualifying relative (who is not a qualifying child).

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

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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 $3,650

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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2009 standard deductionSingle $ 5,700

Married Filing Joint (MFJ) $11,400Qualifying Widow(er) $11,400 also known as Surviving Spouse

Head of Household (HOH) $ 8,350

Married Filing Separate (MFS) $ 5,700

*Plus additional amounts for blindness or over 65: $1,100 if MFJ, MFS or qualifying widow(er) and $1,400 if HOH or Single

For 2009 only, may add sales tax on qualified motor vehicle purchased after 2/16/09 and lesser of $500 (or $1,000 MFJ) or

actual real estate taxes paid to standard deduction

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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 2009.

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

Example 2: Tia is 18 and has dividend income of $1,500 (not earned)

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

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Basic Gain/Loss Model

Amount Realized*

- Adjusted Basis**

Realized Gain/Loss

*Sales Price - Sales Expenses

**Cost - Accumulated Depreciation

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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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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Facts: Noah purchased Sony AAA bonds in 2001 for $47,600. In 2009, 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 ___________

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