Chapter 4.Individual Income

Tax Overview Howard Godfrey, Ph.D., CPA

Professor of Accounting ©Howard Godfrey-2012

4. Indiv. Income Tax Overview1. Formula for calculating an individual taxpayer's taxes payable or refund, explain each formula component.2. Requirements for taxpayer's personal & dependency exemptions.3. Taxpayer's filing status.

Tax Formula

Gross income- Less Excl.

Less: Deductions for adjusted gross income

Equals: Adjusted Gross Income (AGI)

Less: Deductions from AGI (greater of

itemized or standard deduction)

Less: Exemptions (personal & dependency)

Equals: Taxable income (loss)

Individual Tax Model-1.

Taxable income

Times: Tax rates

Equals: Gross income tax liability

Plus: Additions to tax

Less: Tax credits or prepayments

Equals: Tax owed or refund due

Individual Tax Model-2

Mary’s salary is $120,000 per year. Her federal income tax withheld is $20,000. There is no state income tax. What is her take-home pay for the year? See following slide.

Salary $120,000Federal income tax withheld: (20,000) Maximum for Soc. Sec. $106,800Social Security base 106,800

Rate-Social Security 6.20%Social Security Tax 6,622

Medicare base 120,000

Rate-Medicare Tax 1.45%Medicare Tax 1,740FICA (Soc. Security & Medicare) (8,362) Take-home pay 91,638$ Note that the 6.2% is temporarily reduced in 2011 and 2012.

Mary-2011

General Tax Formula ($000)Gross Income - Form 1040-Pg 1 $110

Deductions For A.G.I. (10) Adjusted Gross Income (AGI) 100 Exemptions (6) Regular Itemized Ded. (15) Misc. Itemized Ded. (5)

Less 2% of AGI 2 Deductible Amount (3)

Total Deductions From AGI (24) Taxable Income $76

IncomeWhat is Gross Income?What are Exclusions?What is a Deferral?

Deductions

What are some types of deductions?

Rate Start End

10% $0 $17,00015% $17,000.01 $69,00025% $69,000.01 $139,35028% $139,350.01 $212,30033% $212,300.01 $379,15035% $379,150.01

Income Tax -2011-Joint

Compute income taxfor married couplewith this information.See next two slidesSalaries $125,000 Deductions ($25,000)Taxable Income on Joint Return $100,000

Gross Income-Salary $125,000

Deductions ($25,000)

Taxable Income on Joint Return $100,000

2011 Cumulative Layers Rate Base Tax 1st Layer $17,000 $17,000 10.00% $17,000 $1,700.00

2nd layer $69,000 $52,000 15.00% $52,000 $7,800.00

3rd layer $139,350 $70,350 25.00% $31,000 $7,750.00

4th layer $212,300 $72,950 28.00% $0 $0.00

5th layer $379,150 $166,850 33.00% $0 $0.00

6th layer Excess 35.00% $0 $0.00

Taxable Income and Income Tax $100,000 $17,250.00

Base Rate Tax

Top layer 69,000 $9,500.00

Amt above 31,000 25% $7,750.00

Income 100,000

Total Tax $17,250.00

Tax Computation- Joint Return

See rates on book cover.

Deduction vs. Credit• Mary spends $1,000 for child care

for her child. This is necessary for Mary to have a job.• Why would Mary prefer to treat

the expenditure as an income tax credit rather than as an income tax deduction?

Deduction vs. Credit• Mary spends $1,000 for child care for her

child. Why would Mary prefer to treat the expenditure as an income tax credit rather than as an income tax deduction?• A $1,000 credit reduces tax by

$1,000. A deduction reduces taxable income.

Exclusions from Gross Income (All Taxpayers)• Tax-exempt interest• Nontaxable stock dividends• Nontaxable stock rights• Proceeds of life insurance policies• Tax refunds to the extent no prior tax benefit

was received• Disallowed and deferred gains and losses on

property transactions• Unrealized gains and losses

Exclusions from Gross Income (Individual Taxpayers Only) • Nontaxable part of pension plan distributions• Nontaxable portion of Social Security benefits• Damages awarded for physical injury• Gifts and inheritances• Welfare benefits (food stamps, workman’s

compensation and family aid)• $250,000 or $500,000 gain on sale of personal

residence• Scholarships• Qualified employee fringe benefits

Deductions • Corporations – all business expenses are

deductible if ordinary, necessary, and reasonable (unless disallowed by law)

• Individuals–Deductions for AGI–Deductions from AGI – greater of

itemized deductions or standard deduction–Personal and dependency exemptions

Deductions For AGI – (Form 1040- Pg 1)“Above-the-line” deductions

• Property losses on Schedule D - $3,000• Contributions to pension & retirement plans• Health savings account contributions• Moving expenses• One-half of self-employment taxes• Self-employed health insurance premiums• Penalty on early withdrawal of savings• Tuition deduction ($4,000 limit) • Student loan interest ($2,500 limit)• Alimony paid

Itemized Deductions – Individuals (Sched. A)• Medical (dental) expenses (in excess of 7.5% AGI)• Taxes (state, local, and foreign income and property

taxes) • Interest (mortgage and investment)• Charitable contributions (up to 50% AGI)• Casualty & theft losses (in excess of 10% AGI)• Miscellaneous including unreimbursed employee

business expenses and investment expenses (in excess of 2% AGI)

• Gambling losses (up to gambling winnings)

Standard Deduction

Standard Deductions - 2011$5,800 single (unmarried) individual

$11,600 married filing a joint return

$11,600 surviving spouse

$8,500 head of household

$5,800 married filing separately

Personal & dependency exemptions $3,700 taxpayer and dependent

Standard Deduction & Exemptions

In 2011, Mr. and Ms. Jones have combined salaries of $60,000. Their only expenditures affecting the tax return are state income taxes of $6,000, mortgage interest of $5,000 and real estate taxes amounting to $1,000. They have two small children whom they support, and file a joint return. What is their taxable income for 2011?

Gross income $60,000

Deduct. for AGI

Adj. Gross Income 60,000

Less:

1a. Standard Ded.

1b. Itemized Ded.

2. Exemptions

Taxable Income

Mr. and Ms. Jones

Gross income $60,000

Deduct. for AGI

Adj. Gross Income 60,000

Less:

1a. Standard Ded. 11,600

1b. Itemized Ded. 12,000

(12,000)

2. Exemptions 3,700 14,800 (14,800)

Taxable Income $33,200

Tax Before Credits

Mr. and Ms. Jones

Laura Bush, age 48. No dependents.Salary $38,000 Dividend income $2,000 Income from rents $16,000 She also has this information:

Contribution to IRA $2,000 Expenses relating to rents $9,000 Cost of stock market publications $1,000 Charitable contributions $1,500 Unreimbursed employee expenses $1,000

Her adjusted gross income is:a. $42,000 b. $43,000 c. $45,000 d. $40,600

Facts ReturnSalary $38,000 Dividend income $2,000 Income from rents $16,000

SubtotalShe also has this information:

Contribution to IRA $2,000 Expenses relating to rents $9,000 Cost of stock publications $1,000 Charitable contributions $1,500 Employee expenses $1,000 SubtotalAdjusted Gross Income (AGI)

Laura Bush, age 48. No dependents.

Facts ReturnSalary $38,000 $38,000 Dividend income $2,000 $2,000 Income from rents $16,000 $16,000

Subtotal $56,000 She also has this information:

Contribution to IRA $2,000 $2,000 Expenses relating to rents $9,000 $9,000 Cost of stock publications $1,000 Charitable contributions $1,500 Employee expenses $1,000 Subtotal $11,000 Adjusted Gross Income $45,000

Laura Bush, age 48. No dependents.

Standard DeductionHarry and Silvia, a married couple, are both age 67 and legally blind. What is their standard deduction for 2012?

Standard Deduction Pg 6-33

Harry & Silvia-Married Year: 2012

Basic Standard Ded. $11,900Additional Std. Ded.

Amount Number

$1,150 4 4,600

Total Std. Deduction $16,500

Exemptions

Shereal Wallace. Sept 29, 2011Ms. Davis (age 21) and her 2-year-old Daughter, M.D., were homeless until Shereal took them into his home in January. Ms. Davis is Shereal's niece. They lived in his home until October. Ms. Davis is not married, and the father of M.D. is unknown. Ms. Davis received her certificate of high school equivalence in September. While Ms. Davis and M.D. resided with Shereal, Ms. Davis did not have a job and received no other income. Shereal claimed dependency exemption deductions for Ms. Davis and M.D. and a child tax credit for M.D. The IRS Disagreed. What do you say?

A taxpayer may claim a dependency exemption deduction for an individual who is either a “qualifying child” or a “qualifying relative”. Secs. 151(c), 152(a).

To be “qualifying child”, an individual must: (A) Bear a qualifying relationship to taxpayer;

(B) have the same home as the taxpayer for more than one-half of the taxable year; (C) meet certain age requirements; and (D) not have provided more than half of his or her own support in year. Sec. 152(c)(1).

Qualifying Child RelationshipAn individual bears a qualifying relationship to the taxpayer if that individual is “a brother, sister, stepbrother, or stepsister of the taxpayer or a descendant of any such relative.” Sec. 152(c)(2)(B).

Age Requirement. An individual must be younger than 19 or be a student younger than 24. Sec. 152(c)(3)(A). “Student” is an individual who in each of 5 months of the year is a full-time student at an educational institution that normally maintains a regular faculty, curriculum, and enrolled students …. Secs. 152(f)(2), 170(b)(1)(A)(ii).

M.D. was 2 at the end of the year and meets the age requirement. Ms. Davis was 21 at the end of the calendar year. Ms. Davis obtained her certificate of high school equivalency in September, but there is no evidence that she was a full-time student …in at least 5 months of the year.

152(c) Qualifying Child. “Qualifying child" means, … an individual(A) who bears a relationship to the taxpayer described in paragraph (2), [next slide](B) who has the same principal place of abode as the taxpayer for more than one-half of the year,(C) who meets age requirements of paragraph (3),(D) who has not provided over one-half of such individual's own support for the calendar year in which the taxable year of the taxpayer begins, and(E) who has not filed a joint return (other than only for a claim of refund) with the individual's spouse ...

152(c)(2) Relationship. For …paragraph (1)(A), an individual bears a relationship to the taxpayer described in this paragraph if such individual is—(A) a child of the taxpayer or a descendant of such a child, or(B) a brother, sister, stepbrother, or stepsister of taxpayer or a descendant of any such relative.

152(c)(3) Age requirements. (A) …an individual meets the requirements of this paragraph if such individual is younger than the taxpayer claiming such individual as a qualifying child and(i) has not attained age of 19 as of close of year in which the taxable year of taxpayer begins, or(ii) is a student who has not attained the age of 24 as of the close of such calendar year.(B) Special rule for disabled. In the case of an individual who is permanently and totally disabled (as defined in section 22(e)(3)) at any time during such calendar year, the requirements of subparagraph (A) shall be treated as met with respect to such individual.

152(d) Qualifying Relative. …The term "qualifying relative" means, with respect to any taxpayer for any taxable year, an individual

(A) who bears a relationship to the taxpayer described in paragraph (2), [next slide](B) whose gross income for the year is less than the exemption amount (defined in sec. 151(d)),(C) with respect to whom the taxpayer provides over one-half of the individual's support for the year…, and(D) who is not a qualifying child of taxpayer or of any other taxpayer for the year….

152(d)(2) Relationship (of a Qualifying Relative).… any of the following with respect to the taxpayer:(A) A child or a descendant of a child.(B) A brother, sister, stepbrother, or stepsister.(C) The father or mother, or an ancestor of either.(D) A stepfather or stepmother.(E) A son or daughter of a brother or sister of the taxpayer.(F) A brother or sister of the father or mother of taxpayer.(G) A son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.(H) An individual (other taxpayer’s spouse…) who, for the year, has the same principal place of abode as the taxpayer and is a member of the taxpayer's household.

Child Tax Credit [Sec. 24(c)](c) QUALIFYING CHILD. For purposes of this section-(1) IN GENERAL. The term “qualifying child_ means a qualifying child of the taxpayer (as defined in section 152(c)) who has not attained age 17.(2) EXCEPTION FOR CERTAIN NONCITIZENS.The term “qualifying child shall not include any individual who would not be a dependent if subparagraph (A) of section 152(b)(3) were applied without regard to all that follows “resident of the United States.”

Filing Status

Filing Status, See:Sec. 2(a) Surviving SpouseSec. 2(b) Head of

householdSec. 6013(a) and (d) Joint

Return

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