The Individual Income Tax Return

HISTORY AND OBJECTIVES OF THE TAX SYSTEM

The United States income tax was authorized by the Sixteenth Amendment to theConstitution on March 1, 1913. Prior to the adoption of this Amendment, the UnitedStates government had levied various income taxes for limited periods of time. Forexample, an income tax was used to help finance the Civil War. The finding by the courtsthat the income tax law enacted in 1894 was unconstitutional eventually led to the adop-tion of the Sixteenth Amendment. Since adoption of the Amendment, the constitution-ality of the income tax has not been questioned by the federal courts.

Many people believe the sole purpose of the income tax is to raise revenue to operatethe government. This belief is not accurate. The income tax is used also as a tool of eco-nomic and social policies. Realizing that, the beginning tax student can better under-stand why and how the tax law has become so complex. The tax law has many goals otherthan raising revenue. These goals fall into two general categories—economic goals andsocial goals—and it is often unclear which goal a specific tax provision was written tomeet. Tax provisions have been used for such economic motives as reduction of unem-ployment, expansion of investment in productive (capital) assets, and control of infla-tion. Specific examples of economic tax provisions are the limited allowance for expens-ing of capital expenditures and the accelerated cost recovery system (ACRS or MACRS)of depreciation. In addition to pure economic goals, the tax law is used to encourage cer-tain business activities and industries. For example, an income tax credit encouragesbusinesses to engage in research and development activities and a special deduction forsoil and water conservation expenditures, related to farm land, benefits farmers.

Social goals have also resulted in the adoption of many specific tax provisions. Thechild and dependent care credit, the earned income credit, and the charitable contri-bution deduction are examples of tax provisions designed to meet social goals. Socialprovisions may influence economic activities, but they are written primarily to encour-age taxpayers to undertake activities to benefit themselves and society.

CHAPTER 1

The Individual Income Tax Return

ObjectivesAfter completing this chapter, you should:• Know the history and objectives of U.S. tax law.• Know the different entities subject to tax and reporting requirements.• Understand the tax formula for individual taxpayers.• Be able to complete a simple individual income tax return.

SECTION 1.1

1-1

? WOULD YOU BELIEVE...

Self-Study Problem 1.1

1-2 Chapter 1 • The Individual Income Tax Return

An example of a provision that has both economic and social objectives is the provi-sion allowing the gain on sale of a personal residence up to $250,000 ($500,000 if mar-ried) to be excluded from taxable income. From a social standpoint, this helps a familyafford a new home, but it also helps achieve the economic goal of ensuring that theUnited States has a mobile workforce.

Indicate by a check mark whether you think each of the following tax provisions was designed to meet an economic goal or a social goal of the tax law. If it is not clear which was the primary goal of the provision, check the box labeled both.

The size of the tax code has grown from around 400,000 words in 1955 to over 1,300,000words today. Yale Law Prof. Michael J. Graetz is quoted as saying, “The tax code is now morethan six times longer than Tolstoy’s ‘War and Peace’ and ‘considerably harder to parse’” (WallStreet Journal Tax Report, January 24, 2001).

REPORTING AND TAXABLE ENTITIES

Under United States tax law, there are five basic taxable or reporting entities. They areindividuals, corporations, partnerships, estates, and trusts. The taxation of individuals isthe major topic of this text; an overview of the taxation of partnerships and corporationsis presented in Chapters 10 and 11, respectively. Taxation of estates and trusts is a spe-cialized area not covered in this text.

GOALTAX PROVISION Economic Social Both

1. The child care credit

2. The earned income credit

3. The medical expense deduction

4. The deduction for a donation to a church

5. The credit for research and development expenditures

6. The personal exemption

7. The Accelerated Cost Recovery System

8. The disallowance of a deduction for finesand penalties

9. The home mortgage interest deduction

10. The exclusion of gain on sale of a personal residence

SECTION 1.2


1-3Section 1.2 • Reporting and Taxable Entities

The IRS reports that net revenue collections for 2003 came from the following sources.Individual income taxes 51%Corporate income taxes 10%Employment, excise and other taxes 39%

The IndividualThe taxable unit most people are familiar with is the individual. Taxable income for indi-viduals generally includes wages, salary, self-employment earnings, rent, interest, anddividends. Individual taxpayers file a Form 1040EZ, a Form 1040A, or a Form 1040. TheForm 1040EZ is the simplest tax form to use, but it may be used only by taxpayers whohave the following characteristics:

1. The taxpayer must be single or married filing a joint return;2. The taxpayer must not be age 65 or over and/or blind;3. The taxpayer must not claim any dependents;4. The taxpayer’s taxable income must be less than $50,000;5. The taxpayer’s income must include only wages, salaries, tips, unemployment

compensation, taxable scholarships and fellowships, and $1,500 or less of tax-able interest income;

6. The taxpayer must not have received advance earned income credit payments;and

7. The taxpayer must not claim a student loan interest deduction or an educationcredit.

Many taxpayers who cannot file Form 1040EZ file Form 1040A. Generally, Form1040A is filed by taxpayers who are not self-employed and do not benefit from itemizingtheir deductions. Form 1040A allows a taxpayer the following items not allowed for tax-payers who file Form 1040EZ:

1. The additional standard deduction for being age 65 or over and/or blind;2. Exemptions for dependents;3. Dividend and interest income of any amount;4. Pension and annuity income;5. Payments from an IRA;6. Taxable social security benefits;7. The deduction for contributions to an individual retirement account (IRA);8. The child and dependent care credit and the child tax credit;9. The credit for the elderly;

10. Any allowable filing status; 11. Estimated tax payments; 12. The adoption credit;13. Student loan interest, education credits and the tuition and fees deduction;14. Capital gain distributions from mutual funds;15. Educator expenses;16. Advance earned income credit payments;17. The alternative minimum tax; and18. The retirement savings contributions credit.Form 1040, the long form, is used by all individual taxpayers who must file a tax

return and do not qualify to file a Form 1040EZ or a Form 1040A.


An individual taxpayer’s interest income (over $1,500) and dividend income (over$1,500) are reported on Schedule B of Form 1040 (or Form 1040A, Schedule 1), whileincome from a trade or business, other than farm or ranch activities, is included onSchedule C. Farm or ranch income is reported on Schedule F. The supplementalincome schedule, Schedule E, is used to report rental or royalty income. If an individualtaxpayer has capital gains or losses, he or she must generally file Schedule D to reportthose gains or losses. Schedule A is completed by individuals who itemize their deduc-tions. Itemized deductions on Schedule A include medical expenses, taxes, interest,charitable contributions, casualty and theft losses, and other miscellaneous deductions.These tax forms and schedules and some less common forms are presented in this text.

The CorporationCorporations are subject to the United States income tax and must report income annu-ally on a Form 1120-A (short form) or a Form 1120 (long form). The tax rate schedulefor corporations is:

Taxable Of theIncome Over But Not Over The Tax Is Amount Over

0 $50,000 15% 0$50,000 75,000 $7,500 + 25% $50,00075,000 100,000 13,750 + 34% 75,000

100,000 335,000 22,250 + 39% 100,000335,000 10,000,000 113,900 + 34% 335,000

10,000,000 15,000,000 3,400,000 + 35% 10,000,00015,000,000 18,333,333 5,150,000 + 38% 15,000,00018,333,333 — 6,416,667 + 35% 18,333,333

Some corporations may elect S Corporation status. An S Corporation does not payregular corporate income taxes; instead, the corporation’s income passes through to theshareholders and is included on their returns. Chapter 11 includes an explanation of theS Corporation.

The PartnershipThe partnership is not a taxable entity; instead it is a reporting entity. Generally, allincome or loss of a partnership is included on the tax returns of the partners. However,a partnership must file a Form 1065 to report the amount of income or loss and showthe allocation of the income or loss to the partners. The partners, in turn, report theirshare of ordinary income or loss on their tax returns. Other special gains, losses, income,and deductions of the partnership are reported and allocated to the partners separate-ly, since the items are given special tax treatment at the partner level. Capital gains andlosses, for example, are reported and allocated separately and the partners report theirshare on Schedule D of their individual income tax returns.

SUMMARY OF MAJOR TAX FORMS AND SCHEDULES

Form or Schedule Description1040EZ Individual return – single and joint filers with no dependents1040A Individual return, short form1040 Individual return, long formSchedule A Itemized deductionsSchedule B Interest and dividend incomeSchedule C Profit or loss from business or professionSchedule D Capital gains and losses

1-5Section 1.3 • The Tax Formula for Individuals

Schedule E Supplemental (rent and royalty) incomeSchedule F Farm and ranch income1120 Corporate tax return, long form1120-A Corporate tax return, short form (for small corporations)1120S S Corporation tax return1065 Partnership information returnSchedule K-1 Partner’s share of partnership results1041 Fiduciary (estates and trusts) tax return

All of the forms listed above and more are available at the IRS Web site(http://www.irs.gov).

Indicate which is the most appropriate form or schedule for each of the following items. Unlessotherwise indicated in the problem, assume the taxpayer is an individual.

ITEM Form or Schedule

1. Bank interest income of $1,600 received by a taxpayer who itemizes deductions ____________

2. Capital gain on the sale of AT&T stock ____________3. Income from a farm ____________4. Income of a trust ____________5. An individual partner’s share of partnership income reported by

the partnership ____________6. Salary of $70,000 for a taxpayer who itemizes deductions ____________7. Income from a sole proprietorship business ____________8. Income from rental property ____________9. Dividends of $2,000 received by a taxpayer who does not

itemize deductions ____________10. Income of a large corporation ____________11. Loss for a partnership ____________12. Charitable contribution deduction for an individual who

itemizes deductions ____________13. Single individual with no dependents whose only income is

$18,000 (all from wages) and who does not itemize deductions ____________

THE TAX FORMULA FOR INDIVIDUALS

Individual taxpayers calculate their tax in accordance with a tax formula. Understandingthe formula is important, since all tax calculations are based on the result. The formula is:

Gross Income– Deductions for Adjusted Gross Income

——————————————————————————= Adjusted Gross Income– Greater of Itemized Deductions or the Standard Deduction– Exemptions

—————–——= Taxable Income× Tax Rate

——————= Gross Tax Liability– Credits and Prepayments

—————————————————= Tax Due or Refund

————————–————————————–————


SECTION 1.3



Gross IncomeThe calculation of taxable income begins with gross income. Gross income includes allincome, unless the tax law provides for a specific exclusion. The exclusions from grossincome are discussed in Chapter 2.

Deductions for Adjusted Gross IncomeThe first category of deductions are the deductions for adjusted gross income. Thesedeductions include trade or business expenses, certain reimbursed employee businessexpenses paid under an accountable plan, alimony payments, moving expenses, certaineducator expenses, student loan interest, a tuition and fees deduction, the penalty onearly withdrawal from savings, and contributions to qualified retirement plans. Laterchapters explain these deductions in detail.

Adjusted Gross IncomeThe amount of adjusted gross income is important, since it is the basis for several deduc-tion limitations, such as the limitation on medical expenses. A taxpayer’s adjusted grossincome is also used to determine the phase-out of the otherwise allowable itemizeddeduction and personal and dependency exemption amounts.

The Wall Street Journal (Tax Report, April 24, 1996) reported: “Humorist Dave Barry says theIRS is making progress in ‘its mission to develop a tax form so scary that merely reading it willcause the ordinary taxpayer’s brain to explode.’ He cites Schedule J, Form 1118: ‘SeparateLimitation Loss Allocations and Other Adjustments Necessary to Determine Numerators ofLimitation Fractions, Year-End Recharacterization Balances, and Overall Foreign LossAccount Balances.’”

Standard Deduction or Itemized DeductionsItemized deductions are personal items that Congress has allowed as deductions.Included in this category of deductions are medical expenses, certain interest expense,certain taxes, charitable contributions, casualty losses, and other miscellaneous items.Taxpayers should itemize their deductions only if the total amount exceeds their stan-dard deduction amount. The following table gives the standard deduction amounts for 2004.

Filing Status 2004 Standard DeductionSingle $4,850Married, filing jointly 9,700Married, filing separately 4,850Head of household 7,150Qualifying widow(er) 9,700

Taxpayers who are 65 years of age or older or blind are entitled to an additional stan-dard deduction amount. For 2004, the additional standard deduction amount is $1,200for unmarried taxpayers and $950 for married taxpayers and surviving spouses.Taxpayers who are both 65 years of age or older and blind are entitled to two addition-al standard deduction amounts. See Section 1.7 for a complete discussion of the basicand additional standard deduction amounts.

1-7Section 1.4 • Who Must File and Where to File

ExemptionsExemptions are worth $3,100 each for 2004. The two types of exemptions, personal anddependency, will be described later in this chapter.

The Gross Tax LiabilityA taxpayer’s gross tax liability is obtained by reference to the tax table or use of a tax rateschedule. Tax credits and prepayments are subtracted from gross tax liability to calculatethe net tax due the government or the refund due the taxpayer.

Bill is a single taxpayer. In 2004, his salary is $28,500 and he has interest income of $1,500. In addition, he has deductions for adjusted gross income of $2,100 and $6,250 of itemizeddeductions. If Bill claims one exemption for this year, calculate the following amounts:

1. Gross income $ ____________2. Adjusted gross income $ ____________3. Standard deduction or itemized deduction amount $ ____________4. Taxable income $ ____________

WHO MUST FILE AND WHERE TO FILE

Several conditions must exist before a taxpayer is required to file a U.S. income taxreturn. These conditions primarily relate to the amount of the taxpayer’s income andthe taxpayer’s filing status. Figures 2 through 4 summarize the filingrequirements for taxpayers in 2004. If a taxpayer has any nontaxableincome, the amount should be excluded in determining whether thetaxpayer must file a return.

Taxpayers are also required to file a return if they have net earn-ings from self-employment of $400 or more, receive advanced earnedincome credit payments (AEIC), or owe taxes such as Social Securitytaxes on unreported tips. When a taxpayer is not required to file but isdue a refund for overpayment of taxes, a return must be filed to obtainthe refund. A dependent’s basic standard deduction, when filing his orher own tax return, is limited to the greater of $800 or the sum of $250plus earned income up to the basic standard deduction amount for theyear. A dependent who is 65 or over or blind is also allowed an additionalstandard deduction amount.

MONEY TIPS

A good way to increase your income isto increase your education level. Onaverage, a holder of a bachelor’s degreeearns almost twice the amount a highschool graduate earns, according to theU.S. Census Bureau. Those taking somecollege courses or achieving associatedegrees typically earn about 20 percentmore than those with only high schooleducations.

TAX BREAKTaxpayers may provide information on their Form 1040, 1040A, or 1040EZ authorizing theIRS to deposit refunds directly into their bank account. Taxpayers with balances due may paytheir tax bill with a credit card.

In addition, all federal taxes can now be paid via the Internet by both individuals andbusinesses.


SECTION 1.4


A taxpayer who is required to file a return should mail the return to the appropriateInternal Revenue Service Center. Figure 1 lists these locations. Generally, individualreturns are due on the fifteenth day of the fourth month of the year following the closeof the tax year. For a calendar year taxpayer, therefore, the due date is April 15, unlessthe taxpayer requests a filing extension.

FIGURE 1 WHERE TO FILE

FIGURE 2 WHO MUST FILE

1-9Section 1.4 • Who Must File and Where to File

FIGURE 3

FIGURE 4*

*

* By the time this was prepared, the 2004 information was not available.


Indicate by a check mark whether the following taxpayers are required to file a return for 2004in each of the following independent situations:

Filing Required?Yes No

1. Taxpayer (age 45) is single with income of $7,850. _____ _____2. Husband (age 67) and wife (age 64) with income of $16,250,

filing a joint return. _____ _____3. Taxpayer is a college student with salary from a part-time job

of $6,000. She is claimed as a dependent by her parents. _____ _____4. Taxpayer has net earnings from self-employment of $4,000. _____ _____5. Taxpayers are married with income of $12,800 and file a joint

return. They expect a refund of $600 from excess withholding. _____ _____6. Taxpayer is a waiter and has unreported tips of $450. _____ _____7. Taxpayer is a qualifying widow (age 65) with a dependent

son (age 18) and income of $7,850. _____ _____8. Taxpayer has income of $4,500 and is single. His age is 45

and he received advanced earned income credit payments. _____ _____

FILING STATUS AND TAX COMPUTATION

An important step in calculating the amount of a taxpayer’s tax is the determination ofthe taxpayer’s correct filing status. The tax law has five different filing statuses: single;married, filing jointly; married, filing separately; head of household and qualifyingwidow(er). A tax table that must be used by most taxpayers, showing the tax liability forall five statuses, is provided in Appendix A. The tax table can be used unless the taxpay-er’s taxable income is $100,000 or over, or the taxpayer is using a special method to cal-culate the tax liability. If taxpayers can use the tax table to determine their tax, they mustdo so; otherwise, a tax rate schedule is used. Single taxpayers use Tax Rate Schedule X;married taxpayers or qualifying widows(ers) use Tax Rate Schedule Y-1; married taxpay-ers filing separately use Tax Rate Schedule Y-2; and taxpayers filing as heads of house-holds use Tax Rate Schedule Z. The tax rate schedules are also presented in Appendix A.

Single Filing StatusTaxpayers who do not qualify for married, qualifying widow(er), or head of household sta-tus file as single. This status must be used by taxpayers who are unmarried or legally sepa-rated from their spouses by divorce or separate maintenance decree as of December 31 ofthe tax year. State law governs whether a taxpayer is married, divorced, or legally separat-ed. If a taxpayer’s spouse dies during the year, the taxpayer’s status is married for that year.

Married Filing JointlyTaxpayers are married for tax purposes if they are married on December 31 of the tax year.Also, in the year of one spouse’s death, the spouses are considered married for the full year.In most situations, married taxpayers pay less tax by filing jointly than by filing separately.Married taxpayers may file a joint return even if they did not live together for the entire year.

As the law currently stands, same-sex couples can’t file joint returns. The questioncame up recently when Massachusetts recognized same-sex marriages. For Federal taxpurposes, such marriages are not recognized.


SECTION 1.5

1-11Section 1.5 • Filing Status and Tax Computation

Allowing married couples to file joint returns was first proposed in 1941. The proposalsparked a controversy, and according to the Kiplinger Tax Letter (April 7, 1995), opponents ofjoint filing were called champions of emancipated womanhood.

Married Filing SeparatelyMarried taxpayers may file separate returns and should do so if it reduces their total taxliability. They may file separately if one or both had income during the year. If separatereturns are filed, both taxpayers must compute their tax in the same manner. For exam-ple, if one spouse itemizes deductions, the other spouse must also itemize deductions.Each taxpayer reports his or her income, deductions, and credits and is responsible onlyfor the tax due on his or her return. If the taxpayers live in a community property state,they must follow state law to determine community income and separate income. Thecommunity property states include Arizona, California, Idaho, Louisiana, Nevada, NewMexico, Texas, Washington and Wisconsin. See Chapter 6 for additional discussionregarding income and losses from community property.

A legally married taxpayer may file as head of household (based on the general filingstatus rules), if he or she qualifies as an abandoned spouse. A taxpayer qualifies as anabandoned spouse only if all of the following requirements are met:

1. A separate return is filed,2. The taxpayer paid more than half the cost (rent, utilities, etc.) to keep up his or

her home during the year,3. The spouse did not live with the taxpayer at any time in the last six months of

the year, and4. For over six months during the year the home was the principal residence for a

dependent child, stepchild or adopted child. Under certain conditions a fosterchild may qualify as a dependent.

Head of HouseholdIf an unmarried taxpayer can meet special tests, he or she is allowed to file as head ofhousehold. Head of household rates are lower than rates for single or married filing sep-arately. A taxpayer qualifies for head of household status if both of the following condi-tions exist:

1. The taxpayer was unmarried (or abandoned) as of December 31 of the tax year,and

2. The taxpayer paid more than half of the cost of keeping a home that was theprincipal place of residence of a dependent.


TAX BREAKIn certain circumstances, married couples may be able to reduce their total tax liability byfiling separately. For instance, since some itemized deductions, such as medical expensesand casualty losses, are reduced by a percentage of adjusted gross income (discussed inChapter 5), a spouse with a casualty loss and low separate adjusted gross income may bebetter off filing separately.


If the dependent is the taxpayer’s parent, the parent need not live with the taxpayer.Also, an unmarried child, grandchild, adopted child, or stepchild does not have to be a dependent; the child must only live with the taxpayer. Any other qualifying individ-ual, such as a foster child, must be a dependent of the taxpayer and live in the taxpay-er’s home.

Surviving SpouseA taxpayer may continue to benefit from the joint return rates for two years after thedeath of his or her spouse. To qualify to use the joint return rates, the widow(er) mustpay over half the cost of maintaining a household where a dependent child, stepchild,adopted child, or foster child lives. After the two-year period, these taxpayers usuallyqualify for the head of household filing status.

Tax ComputationFor 2004, there are six income tax brackets (10 percent, 15 percent, 25 percent, 28 per-cent, 33 percent, and 35 percent). The individual tax rates for 2004 are presented in theTax Rate Schedules in Appendix A. The tax rate schedule for single taxpayers is sum-marized below:

When calculating their tax liability, taxpayers who have adjusted gross income inexcess of threshold amounts are required to reduce the amount of their otherwise allow-able personal exemptions and itemized deductions. The provisions for reducing exemp-tions and itemized deduction amounts result in a marginal tax rate that is slightly high-er than the official maximum 35 percent rate. These provisions will be discussed later inthis chapter.

The tax rates applicable to net long-term capital gains range from 5 percent to 28 per-cent depending on the taxpayer’s tax bracket and the kind of capital asset. The calcula-tion of the tax on capital gains is discussed in detail in Chapter 8, and the applicable taxrates are discussed in Section 1.9 of this chapter.

The 2003 Tax Act introduced new lower rates for qualifying dividends, discussed indetail in Chapter 2, effective for tax years before 2009. After 2008, tax rates revert to pre-2003 tax law. The new tax rates on dividends are as follows:

Qualifying Dividend RateOrdinary Tax Bracket 2003–2007 200810% and 15% 5% 0%Higher brackets 15% 15%

1-13Section 1.6 • Personal and Dependency Exemptions

EXAMPLE Carol, a single taxpayer claiming one exemption, has adjusted gross incomeof $120,000 and taxable income of $105,000 for 2004. Her tax is calculatedusing the 2004 Tax Rate Schedule from Appendix A as follows:

$24,027 = $14,325 + 28% × ($105,000 – 70,350)

EXAMPLE Meg is a single taxpayer during 2004. Her taxable income for the year is$27,530. Using the tax table in Appendix A, her gross tax liability for the yearis found to be $3,771.

Indicate the filing status (or statuses) in each of the following independent cases, using this legend:

A – Single D – Head of householdB – Married, filing a joint return E – Qualifying widow(er)C – Married, filing separate returns

FilingCase Status

1. The taxpayers are married on December 31 of the tax year. ____________2. The taxpayer is single, with a dependent child living in

her home. ____________3. The taxpayer is unmarried and is living with his girlfriend. ____________4. The taxpayer is married and his spouse left in midyear

and has disappeared. The taxpayer has no dependents. ____________5. The unmarried taxpayer supports her dependent mother,

who lives in her own home. ____________6. The taxpayer is divorced and her son lived with her

all year. Her son is a dependent of his father. ____________7. The taxpayer’s wife died last year. His 15-year-old

dependent son lives with him. ____________

PERSONAL AND DEPENDENCY EXEMPTIONS

Taxpayers are allowed two types of exemptions: personal and dependency. For 2004,each exemption reduces adjusted gross income by $3,100. However, the exemptiondeduction is phased out for high income taxpayers. If a taxpayer’s adjusted gross income(AGI) exceeds a certain threshold amount, the exemption deduction is reduced by

TAX BREAKTaxpayers considering marriage may be able to save thousands of dollars by engaging in tax planning prior to setting a date. If the couple would pay less in taxes by filing as mar-ried rather than as single (which will frequently happen if one spouse has low earnings forthe year) they may prefer a December wedding. They can take advantage of the rule thatrequires taxpayers to file as married for the full year even if they were married on the last dayof the year. On the other hand, if filing a joint return would cause the couple to pay more intaxes (which frequently happens if both spouses have high incomes) they may prefer aJanuary wedding.


SECTION 1.6



2 percent for each $2,500 ($1,250 for married taxpayers filing separately) or fractionthereof by which the taxpayer’s AGI exceeds the threshold amount. The thresholdamounts for 2004 are:

Filing Status Threshold AmountSingle $142,700Married, filing jointly 214,050Married, filing separately 107,025Head of household 178,350

The maximum reduction in the exemption deduction is 100 percent.

EXAMPLE In 2004, Heather is a single taxpayer with adjusted gross income of $173,250.She is entitled to one exemption worth $3,100. Heather’s exemption must bereduced by $806 (26% × $3,100). The 26 percent is calculated as follows:

1. ($173,250 – 142,700) / $2,500 = 12.2, which is rounded up to13.

2. 2% × 13 = 26%, the exemption reduction.

Heather’s allowed exemption amount is $2,294 ($3,100 – $806). Theallowed exemption amount may also be calculated using the PersonalExemption Worksheet provided in the Form 1040 Instructions, as shownbelow. If Heather had an exemption for a dependent, this exemption wouldalso be reduced to $2,294.

Personal exemptions are granted to taxpayers for themselves; almost every taxpayerand spouse are each entitled to one personal exemption. Children who may be claimedas dependents on their parents’ tax returns are not allowed to claim a personal exemp-tion for themselves on their own tax returns.

Estimates by the Joint Committee on Taxation show that to rank in the top 1 percent for2001, a taxpayer must have had adjusted gross income of approximately $340,000. Thisgroup paid about 23 percent of total individual taxes for 2001.

3,100

26806

2,294

173,250

142,700

30,55013

x

*

* By the time this was prepared, the 2004 form was not available.


Dependency ExemptionsPlease note: For tax years beginning after 2004 the definition of a qualifying dependent hasbeen changed in accordance with the Working Families Tax Relief Act of 2004. However,for purposes of 2004 tax returns the five dependency tests discussed below are correct.

An additional exemption may be claimed for a person other than the taxpayer or spouseif five tests are met. The five dependency tests relate to income, support, return filed bythe dependent, citizenship, and member of household or relationship.

1. Income testThe dependent must receive less than $3,100 in gross income for the 2004 taxyear. This test does not have to be met if the dependent is the taxpayer’s childwho is (1) under age 19 at the end of the year or (2) a full-time student, underage 24 at the end of the year and in school for at least five months during theyear. To qualify, the school must have a regular teaching staff, a regular enrolledstudent body, and a regular course of study. The term “school” generallyincludes elementary, junior, and senior high schools; colleges and universities;and technical, trade, and mechanical schools. Correspondence schools and on-the-job training do not qualify, unless the on-the-job training consists of farmcourses given by a school or local government.

2. Support testThe dependent must receive over half of his or her support from the taxpayerand spouse. Support includes expenditures for such items as food, lodging,clothes, medical and dental care, and education. To calculate support, the tax-payer uses the actual cost of the above items, except lodging. The value of lodg-ing is calculated at its fair rental value. Money received by the dependent fromnontaxable sources (for example, Social Security) must be used in calculatingsupport. However, funds received by students as scholarships are excluded fromthe support test.

If the dependent is a child of divorced parents who together pay more than half ofthe child’s support, the parent with custody for most of the year is generally entitled tothe exemption. This rule not only applies to cases of divorce and legal separation, butalso to situations in which the parents live apart during the last six months of the tax year.However, the parent without custody may claim the exemption if:

1. The custodial parent agrees on Form 8332 not to claim the dependent for theyear, or

2. A divorce decree executed prior to 1985 states that the noncustodial parent isentitled to the exemption and that parent provided at least $600 in child sup-port during the year.

If a dependent is supported by two or more taxpayers, a multiple support agreementmay be filed. To file the agreement, the taxpayers (as a group) must provide over 50 per-cent of the support of the dependent. Assuming that all other dependency tests are met,the group may give the exemption to any member of the group who provided over 10percent of the dependent’s support.

3. Joint return testThe dependent must not file a joint return with his or her spouse. If neither thespouse nor the dependent is required to file (see the section on filing require-

TAX BREAKIn a multiple support agreement or a divorce, it makes sense to give the exemption to thetaxpayer who will receive the largest tax benefit for the deduction. The additional tax savingscould then be used to further subsidize the dependent’s support.


ments), but they file a return to obtain a refund of tax, they are not consideredto have filed a return for purposes of this test.

4. Citizenship testThe dependent must be a United States citizen, a resident of the United States,Canada, or Mexico, or an alien child adopted by and living with a United Statescitizen in a foreign country.

5. Member of household or relationship testFinally, the dependent must be related to the taxpayer or his or her spouse. Thefollowing relatives qualify:

Child Sister Mother-in-law O r, If RelatedStepchild Grandchild Father-in-law by Blood:Mother Stepbrother Brother-in-law UncleFather Stepsister Sister-in-law AuntGrandparent Stepmother Son-in-law NephewBrother Stepfather Daughter-in-law Niece

A foster child who lives in the taxpayer’s home for the entire year, a legally adoptedchild, or a child placed in the taxpayer’s home by a placement agency qualifies as a childfor this test.

In addition to the relatives listed above, any person who lived in the taxpayer’s homeas a member of the household for the entire year meets the relationship test. But a per-son is not considered a member of the household if at any time during the year the rela-tionship between the taxpayer and the dependent was in violation of local law.

A taxpayer can claim an exemption for a dependent who was born or died during theyear if the dependency tests were met while that person was alive. A dependency exemp-tion may be claimed for a baby born on or before December 31. Taxpayers must providea taxpayer identification number (TIN) for all dependents.

Figure 5 illustrates the dependency tests described above. It is helpful in evaluatingwhether a person qualifies as a dependent.

Indicate in each of the following independent situations the number of exemptions the taxpay-er(s) should claim on their 2004 income tax return. If a test is not mentioned, you should con-sider that it is met.

_____ 1. Abel is 72 years old and married. His wife is 64 and meets the test for blindness. Howmany exemptions should they claim on a joint return?

_____ 2. Betty and Bob are married and have a 4-year-old son. During the year Betty gave birthto a baby girl. How many exemptions should Betty and Bob claim on a joint return?

_____ 3. Charlie supports his 16-year-old brother, who is a full-time student. His brother’sgross income is $4,500 from a part-time job. How many exemptions should Charlieclaim on his return?

_____ 4. Donna and her sister support their mother and provide 60 percent of her support. IfDonna provides 25 percent of her mother’s support and her sister signs a multiplesupport agreement giving Donna the exemption, how many exemptions shouldDonna claim on her return?

_____ 5. Frank is single and supports his son and his son’s wife, both of whom lived with himfor the entire year. The son (age 20) and his wife (age 19) file a joint return to get arefund, reporting $2,500 ($2,000 earned by the son) in gross income. Both the sonand daughter-in-law are full-time students. They do not live in a community propertystate. How many exemptions should Frank claim on his return?

_____ 6. Gary is single and pays $2,000 towards his 20-year-old daughter’s college expenses.The remainder of her support is provided by a $2,500 tuition scholarship. The daugh-ter is a full-time student. How many exemptions should Gary claim on his return?

_____ 7. Helen is 50 years old and supports her 72-year-old mother, who is blind. How manyexemptions should Helen claim on her return?



FIGURE 5 DEPENDENCY EXEMPTION TESTS FLOW CHART

Yes

Yes

No

NODEPENDENCYEXEMPTION

DEPENDENCYEXEMPTION

Yes

Yes

No

No

No

No

No

Yes

Yes

Was the supporttest met?

U.S. Citizen orresident of U.S.,

Mexico, Canada?

Did dependentfile a joint

return?

Was therelationship

test met?

Is T’s child under19 or a full-time

student under 24?

Is gross incomeless than $3,100

(for 2004)?

START


THE STANDARD DEDUCTION

The standard deduction was placed in the tax law to provide relief for taxpayers with fewitemized deductions. The amount of the standard deduction is subtracted from adjust-ed gross income by taxpayers who do not itemize their deductions. If a taxpayer’s grossincome is less than the standard deduction amount, the taxpayer has no taxable income.The standard deduction amounts are presented below:

Filing Status 2004 Standard DeductionSingle $4,850Married, filing jointly 9,700Married, filing separately 4,850Head of household 7,150Qualifying widow(er) 9,700

Additional Amounts for Old Age and BlindnessTaxpayers who are 65 years of age or older or blind are entitled to anadditional standard deduction amount. For 2004, the additional stan-dard deduction amount is $1,200 for unmarried taxpayers and $950for married taxpayers and surviving spouses. Taxpayers who are both

at least 65 years old and blind are entitled to two additional standard deductionamounts. The additional standard deduction amounts are also available for the taxpay-er’s spouse, but not for dependents. An individual is considered blind for purposes ofreceiving an additional standard deduction amount if:

1. central visual acuity does not exceed 20/200 in the better eye with correctinglenses, or

2. visual acuity is greater than 20/200 but is limited to a field of vision not greaterthan 20 degrees.

EXAMPLE John is single and 70 years old in 2004. His standard deduction is $6,050($4,850 plus an additional $1,200 for being 65 years of age or older).

EXAMPLE Bob and Mary are married in 2004 and file a joint return. Bob is age 68, andMary is 63 and meets the test for blindness. Their standard deduction is$11,600 ($9,700 plus $950 for Bob being 65 years or older and another $950for Mary’s blindness).

Individuals Not Eligible for the Standard DeductionThe following taxpayers cannot use the standard deduction, but must itemize instead:

1. A married individual filing a separate return, whose spouse itemizes deductions.2. A nonresident alien.3. An individual filing a short-period tax return because of a change in the annual

accounting period.

EXAMPLE Ed and Ann are married individuals who file separate returns for 2004. Ed item-izes his deductions on his return. Ann’s adjusted gross income is $12,000, and shehas itemized deductions of $900. Ann’s taxable income is calculated as follows:

Adjusted gross income $12,000Itemized deductions (900)Exemption amount (3,100)

——––——–Taxable income $ 8,000

——––——–——––——–Since Ed itemizes his deductions, Ann must also itemize deductions and is

not entitled to use the standard deduction amount.

MONEY TIPS

Taxpayers may be able to reduce taxesby itemizing deductions rather than tak-ing the standard deduction. The U.S.General Accounting Office estimatedthat 2.2 million taxpayers using thestandard deduction instead of itemizingdeductions paid almost $1 billion morethan they should have.

SECTION 1.7

1-19Section 1.8 • Limitation on Total Itemized Deductions

Special Limitations for DependentsThe standard deduction is limited for the tax return of a dependent. The total standarddeduction may not exceed the greater of $800 or the sum of $250 plus dependent’searned income up to the basic standard deduction amount, plus any additional standarddeduction amount for old age or blindness. Also, remember that a dependent may notclaim a personal exemption on his or her own return.

EXAMPLE Penzer, who is 4 years old, earned $4,900 as a child model during 2004. Adependency exemption for Penzer is claimed by his parents on their tax return.Penzer is required to file a tax return, and his taxable income will be $50($4,900 less $4,850, the standard deduction amount). He is not allowed toclaim an exemption for himself. If Penzer had earned only $400, his standarddeduction would be $800 (the greater of $800 or $650 [$400 + $250]) andhe would not owe any tax or be required to file a return.

Indicate in each of the following independent situations the amount of the standard deductionthe taxpayers should claim on their 2004 income tax returns.

_____ 1. Adam is 45 years old, in good health, and single._____ 2. Bill and Betty are married and file a joint return. Bill is 66 years old, and Betty is 60._____ 3. Charlie is 70, single, and blind._____ 4. Debbie qualifies for head of household filing status, is 35 years old, and is in good

health._____ 5. Elizabeth is 9 years old, and her only income is $3,600 of interest on a savings

account. She is claimed as a dependent on her parents’ tax return._____ 6. Frank and Freida are married with two dependent children. They file a joint return, are

in good health, and both of them are under 65 years of age.

LIMITATION ON TOTAL ITEMIZED DEDUCTIONS

Although itemized deductions will be discussed in detail later in the text (see Chapter5), the overall limitation which is dependent on the taxpayer’s amount of adjusted grossincome will be discussed here. If the taxpayer itemizes deductions, rather than claimingthe standard deduction amount, a reduction in the amount of otherwise allowable item-ized deductions may be required.

In 2004, an individual taxpayer whose adjusted gross income exceeds a thresholdamount must reduce the amount of his or her total itemized deductions by 3 percent ofthe excess of adjusted gross income over the threshold amount. The threshold amountfor 2004 is $142,700 ($71,350 for married filing separately). The reduction in the item-ized deductions is limited to 80 percent of itemized deductions other than the deduc-tions for medical expenses, investment interest expense, casualty and theft losses andwagering losses to the extent of wagering gains. Thus, medical expenses, investmentinterest expense, casualty and theft losses and wagering losses are not subject to the over-all limitation.

EXAMPLE Francis and Marcia are married taxpayers who file a joint income tax returnfor 2004. In 2004 they have adjusted gross income of $160,000 and itemizeddeductions of $20,000. The itemized deductions are from charitable contri-butions and state income taxes. Only $19,481 ($20,000 – 519) of the item-ized deductions are allowed in calculating taxable income. The reduction in


SECTION 1.8


the amount of itemized deductions claimed by Francis and Marcia is calcu-lated as follows:

Lesser of:$519 = 3% × ($160,000 – 142,700), or$16,000 = 80% × $20,000

EXAMPLE Use the same facts as in the preceding example, but assume that gross incomewas $180,000 the itemized deductions consist of $18,900 in casualty losses(after the $100 floor and after applying the 10 percent of adjusted grossincome limitation) and $1,100 in state income taxes. In 2004, Francis andMarcia may deduct only $19,120 ($20,000 – 880) of itemized deductions.The reduction in the otherwise allowable itemized deduction amount is equalto the lesser of $1,119 (3% × [$180,000 – 142,700]) or $880 (80% ×$1,100). The reduction in the amount of itemized deductions may also be cal-culated using the Itemized Deductions Worksheet provided in the Form 1040Instructions, as follows:

Elvis and Greta are married taxpayers who file a joint income tax return for 2004. On their 2004income tax return they have adjusted gross income of $145,000 and total itemized deductionsof $12,000. The itemized deductions consist of $5,000 in state income taxes and a $7,000 casu-alty loss (after the $100 floor and after applying the 10 percent of adjusted gross income limi-tation). Of the $12,000 of itemized deductions, what amount is allowed as a deduction in cal-culating taxable income on Elvis and Greta’s 2004 federal income tax return?

$ ____________

A BRIEF OVERVIEW OF CAPITAL GAINS AND LOSSES

When a taxpayer sells an asset there is normally a gain or loss on the transaction.Depending on the kind of asset sold, this gain or loss will have different tax conse-quences. Chapter 8 of this text has detailed coverage of the effect of gains and losses on

20,00018,900

1,100

88019,120

880180,000142,700

37,3001,119

x

x


SECTION 1.9

*

* By the time this was prepared, the 2004 form was not available.

1-21Section 1.9 • A Brief Overview of Capital Gains and Losses

a taxpayer’s tax liability. Because of their importance to the understanding of the calcu-lation of an individual’s tax liability, however, a brief overview of gains and losses will bediscussed here.

The amount of gain or loss realized by a taxpayer is determined by subtracting theadjusted basis of the asset from the amount realized. Generally, the adjusted basis of an assetis its cost less any depreciation (covered in Chapter 7) taken on the asset. The amountrealized is generally what the taxpayer receives from the sale (e.g., the sales price less anycost of the sale). The formula for calculation of gain or loss can be stated as follows:

Gain (or loss) = Amount realized – Adjusted basis

Most gains and losses realized are also recognized for tax purposes. That is, most gainsor losses that occur are included in the taxpayer’s taxable income. The exceptions to thisgeneral tax recognition rule are discussed in Chapter 8.

EXAMPLE Lisa purchased a rental house a few years ago for $100,000. Total deprecia-tion to date on the house is $25,000. In the current year she sells the housefor $155,000 and receives $147,000 after paying selling expenses of $8,000.Her gain on the sale is $72,000 calculated as follows:

Amount realized ($155,000 – $8,000) $147,000Adjusted basis ($100,000 – $25,000) – 75,000

——–————–Gain realized $ 72,000

——–————–——–————–

This gain realized will be recognized as a taxable gain.

Capital Gains and LossesGains and losses can be either ordinary or capital. Ordinary gains and losses are treated fortax purposes just like other items such as salary and interest, and are taxed at ordinary rates.

In general, a capital asset is any property (either personal or investment) held by ataxpayer, with certain exceptions as listed in the tax law (see Chapter 8). Typical assetsthat are not capital assets are inventory and accounts receivable. Examples of capitalassets held by individual taxpayers include stocks, bonds, land, cars, boats, and otheritems held as investments.

The rates on long-term capital gains are summarized as follows:

2004 CapitalOrdinary Tax Bracket Gains Tax Rate10% and 15% 5%All others 15%

Gain from property held twelve months or less is deemed to be short-term capital gainand is taxed at ordinary income tax rates (i.e., up to a maximum rate of 35 percent in2004).

EXAMPLE On October 10, 2004, Chris sells AT&T stock purchased five years ago for$25,000. His adjusted basis (cost) in the stock is $15,000, resulting in a tax-able long-term gain of $10,000. Chris’ taxable income without the sale of thestock is $150,000, which puts him in the 33 percent tax bracket. The tax dueon the long-term capital gain is $1,500 (15% × $10,000) instead of $3,300(33% × $10,000) if the gain on the stock were treated as ordinary income.

When calculating gain or loss the taxpayer must net all capital asset transactions todetermine the nature of the final gain or loss (see Section 8.4 for a discussion of this cal-culation). If an individual taxpayer ends up with a net capital loss (short-term or long-


term), up to $3,000 per year can be deducted against ordinary income. Any unused por-tion in the current year may be carried forward and used to reduce taxable income infuture years (see Section 8.5 for a discussion of capital losses).

EXAMPLE Amy purchased gold coins as an investment. She paid $50,000 for the coins.This year she sells the coins to a dealer for $35,000. As a result, Amy has a$15,000 capital loss. She may deduct $3,000 of the loss against her otherincome this year. The remaining unused loss of $12,000 ($15,000 – $3,000) iscarried forward and may be deducted against other income in future years. Ofcourse, the carryover is subject to the $3,000 annual limitation in future years.

Erin purchased stock in JKL Corporation several years ago for $8,750. In the current year, shesold the same stock for $12,800. She paid a $200 sales commission to her stock broker.

1. What is Erin’s amount realized? $ ______________2. What is Erin’s adjusted basis? $ ______________3. What is Erin’s realized gain or loss? $ ______________4. What is Erin’s recognized gain or loss? $ ______________5. How is any gain or loss treated for tax purposes?

___________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

TAX AND THE INTERNET

Taxpayers and tax practitioners can find a substantial amount of useful information onthe Internet (sometimes called the World Wide Web). The Internet is a global commu-nication system that connects millions of computers throughout the world. Governmentagencies, businesses, organizations, and groups (e.g., the IRS, TurboTax, and ThomsonLearning) maintain sites (also called “homepages”) that contain information of interestto the public. Individuals can gain access to the Internet through a company, a govern-mental agency, an educational institution or by subscribing to a commercial Internetprovider such as CompuServe, America Online, or Yahoo.

The information available on various homepages is subject to rapid change. Discussedbelow are some current Internet sites that are of interest to taxpayers. Taxpayers shouldbe aware that the locations and information provided on the Internet are subject tochange by the site organizer without notice.

TAX BREAKTaxpayers may wish to postpone the sale of capital assets until the holding period is metto qualify for the preferential 15 (or 5) percent long-term capital gains rate. Of course,there is always the risk that postponing the sale of a capital asset such as stock may resultin a loss if the price of the stock decreases below its cost during volatile markets. The eco-nomic risks of a transaction should always be considered along with the tax benefits.


SECTION 1.10

1-23Section 1.11 • Electronic Filing (e-Filing)

The IRS Site, http://www.irs.gov/One of the most useful sites containing tax information is the one maintained by theIRS. There are several places a taxpayer can enter the IRS site. Entering the main IRSsite shown above and clicking on “site map” provides one of the best entrances since itallows the user to quickly scan information available from the IRS. Once a user hasreached this Internet page, he or she is provided quick links to other useful pages con-tained within the IRS site.

In addition, the IRS site has a search function to assist users in locating information.The Forms and Publications search function is particularly useful, and allows the user tolocate and download almost any tax form or publication available from the IRS. A helpfunction is available to aid users of the IRS site. Email access to the IRS is provided forusers who have questions or want to communicate with the IRS.

TurboTax, http://www.turbotax.com/Another useful Internet site for taxpayers is the one maintained by the computer taxsoftware company, TurboTax. There are pages with tips on how to reduce taxes for indi-viduals and businesses. Topics include hints for homeowners, how to handle an IRSaudit, medical expenses, record-keeping requirements and new law changes.

Will Yancey’s Homepage, http://www.willyancey.com/This site is one of the best indexes available with links to other tax, accounting, and legalInternet sites. The site has hundreds of links to commercial Web sites, federal govern-ment Web sites, state and local Web sites, and international Web sites.

Practitioner’s Publishing Co., http://www.ppcnet.com/This is an excellent site that contains a free newsletter. The site also contains informa-tion on financial accounting topics and links to other general accounting topics.

Indicate which of the following statements are true or false by circling the appropriate letter.T F 1. Most commercial computer services, such as America Online, CompuServe, and

Yahoo, provide subscribers access to the Internet.T F 2. The Internet is controlled by the Federal Communications Commission, which is

part of the administrative branch of the United States government.T F 3. Taxpayers can download tax forms and IRS publications from the IRS Internet site.T F 4. A help function is available to aid users of the IRS site.T F 5. The TurboTax Internet site is maintained by Practitioner’s Publishing Co. for users

of its textbooks.

ELECTRONIC FILING (E-FILING)

In Transition: The electronic filing rules discussed below are in constant transition as theIRS works to convert as many taxpayers as possible to electronic filing. Additional infor-mation is available at the IRS Web site (http://www.irs.gov).

Electronic filing (e-filing) is the process of transmitting federal income tax return infor-mation to the IRS Service Center over telephone lines or a computer with a modem orInternet access. For the taxpayer, electronic filing offers a faster refund, either througha direct deposit to the taxpayer’s bank account or by check. IRS statistics show an errorrate of less than 1.0 percent on electronically filed returns, compared with more than 20percent on paper returns.

www

www

www

www


SECTION 1.11



Electronic filing of individual income tax returns may be done with the IRS using oneof three methods. The first is TeleFile. The IRS sends a tax package to taxpayers with verysimple tax returns who are eligible for the TeleFile system. The taxpayer then uses thekeypad of a touch-tone telephone to transmit information to the IRS. Millions of tax-payers have successfully used this program in recent years.

The second electronic filing method is e-filing using a personal computer and tax prepa-ration software. Individual taxpayers may transmit their returns from home, workplaces,libraries or retail outlets. The IRS Web site contains detailed information on this process asthe IRS is constantly working to make e-filing more user friendly and widely available.

The third e-filing option is use of the services of a tax professional, including certifiedpublic accountants, tax attorneys, IRS-enrolled agents and tax preparation businessesqualifying for the IRS tax professional e-filing program.

Electronic filing represents the major significant growth area in computerized tax serv-ices. Approximately 60,000,000 electronic returns were e-filed in 2004 for the 2003 taxyear. In the future, electronic filing will affect the entire professional tax return prepara-tion industry. As a result of electronic filing there will be more computerized tax servicesand the competitive nature of the tax return preparation industry is likely to change.

The IRS recently issued a warning to taxpayers about an identity theft scam where informa-tion is obtained from taxpayers through fake e-mail audit notices. The e-mail looks officialand requests detailed personal information. However, the IRS never sends audit notices totaxpayers by e-mail.

Indicate which of the following statements are true or false by circling the appropriate letter.

T F 1. Compared to paper returns, electronic filings significantly reduces the error ratefor tax returns filed

T F 2. TeleFile is only available for individuals with complex tax returns.T F 3. Individuals may not use electronic filing for their own personal tax returns, but

must engage a tax professional if they wish to e-file.T F 4. Taxpayers who e-file generally receive faster refunds.


Reinforce the tax information covered in this chapter by completing the on-line interactive tutorials located at the Income Tax Fundamentals Web site:http://whittenburg.swlearning.com

INTERACTIVE

QUIZZES

1-25Questions and Problems

QUESTIONS and PROBLEMS

GROUP 1:MULTIPLE CHOICE QUESTIONS

_______ 1. Which of the following is designed solely to meet a social goal of the tax law?a. The home mortgage interest deductionb. The research and development creditc. The Accelerated Cost Recovery Systemd. The charitable contribution deductione. None of the above

_______ 2. Which of the following is a deduction for adjusted gross income in 2004?a. Alimony paymentsb. Medical expensesc. Personal casualty lossesd. Charitable contributionse. None of the above

_______ 3. All of the following are itemized deductions in 2004 except:a. Charitable contributionsb. Casualty lossesc. Moving expensesd. Medical expensese. All of the above are itemized deductions

_______ 4. Ben is a single taxpayer in 2004 who is 32 years old. What is the mini-mum amount of income that he must have to be required to file a taxreturn for 2004?a. $9,700b. $7,150c. $4,850d. $7,950e. None of the above

_______ 5. Joan, whose husband divorced her in 2003, had filed a joint tax returnwith him in 2002. During 2004 she did not remarry and continued tomaintain her home in which her five dependent children lived. In thepreparation of her tax return for 2004, Joan should file as:a. A single individualb. Qualifying widow(er)c. Head of householdd. Married, filing separatelye. None of the above

_______ 6. Margaret and her sister support their mother and together provide 85percent of their mother’s support. If Margaret provides 40 percent of hermother’s support:a. Her sister is the only one who can claim their mother as a dependentb. Neither Margaret nor her sister may claim their mother as a dependentc. Both Margaret and her sister may claim their mother as a dependentd. Margaret and her sister may split the dependency exemptione. Margaret may claim her mother as a dependent if her sister agrees in

a multiple support agreement


_______ 7. Arthur is 65 years old. He supports his father, who is 90 years old andblind. For 2004, how many exemptions should Arthur claim on his tax return?a. 1b. 2c. 3d. 4e. 5

_______ 8. Margaret, age 65, and John, age 62, are married with a 23-year-olddaughter who lives in their home. They provide over half of their daugh-ter’s support, and their daughter earned $3,200 this year from a part-time job. Their daughter is not a full-time student. How many exemp-tions should Margaret and John claim on a joint return for 2004?a. 3b. 4c. 2d. 6e. 5

_______ 9. Lyn, age 65, and Robert, age 66, are married and support Lyn’s father(no taxable income) and Robert’s mother who has $2,200 of grossincome. If they file a joint return for 2004, how many exemptions may Lyn and Robert claim?a. 2b. 3c. 4d. 5e. 6

_______ 10. Ramon, a single taxpayer, has adjusted gross income for 2004 of $149,000and his itemized deductions total $19,000. The itemized deductions con-sist of $8,000 in state income taxes, $8,000 of charitable contributionsand $3,000 in casualty losses (after applying the $100 floor limitation and the 10 percent of adjusted gross income limitation). What amount of itemized deductions will Ramon be allowed to deduct in 2004?a. $19,000b. $18,811c. $15,200d. $16,000e. $189

_______ 11. Which of the following is a capital asset to an individual taxpayer?a. Stocksb. A 48-foot sail boatc. Raw land held as an investmentd. A $50,000 sport utility vehiclee. All of the above are capital assets

_______ 12. Jayne purchased General Motors stock six years ago for $20,000. In 2004she sells the stock for $35,000. What is Jayne’s gain or loss?a. $15,000 long-termb. $15,000 short-termc. $15,000 ordinaryd. $15,000 extraordinarye. No gain or loss is recognized on this transaction


_______ 13. Alexis purchased a rental house three years ago for $285,000. Her depre-ciation to date is $35,000. Due to a decrease in real estate prices, she sellsthe house for only $275,000 in 2004. What is her gain or loss for tax pur-poses?a. $0b. $10,000 lossc. $10,000 gaind. $35,000 losse. $25,000 gain

_______ 14. Shannon has a long-term capital loss of $7,000 on the sale of bonds in2004. His taxable income without this transaction is $48,000. What is histaxable income considering this capital loss?a. $55,000b. $48,000c. $45,000d. $41,000e. Some other amount

GROUP 2:PROBLEMS

1. Indicate whether the following income tax provisions were enacted to meet an economic or social goal of the tax law. Explain the reasons for your answers.a. The tax credit for research and development.

Economic _______ Social _______Why?________________________________________________________________________________________________________________________________________________________________________________________________________

b. The child and dependent care credit.Economic _______ Social _______Why?________________________________________________________________________________________________________________________________________________________________________________________________________

c. The limited allowance for the expensing of capital expenditures.Economic _______ Social _______Why?________________________________________________________________________________________________________________________________________________________________________________________________________

d. The exclusion from gross income of the reimbursement from health insurancepolicies.Economic _______ Social _______Why?________________________________________________________________________________________________________________________________________________________________________________________________________

2. Jason and Mary are married taxpayers in 2004. They are both under age 65 and ingood health. For this tax year they have a total of $41,000 in wages and $500 inter-est income. Jason and Mary’s deductions for adjusted gross income amount to$5,000 and their itemized deductions equal $7,950. They claim two exemptions for the year on their joint tax return.


a. What is the amount of Jason and Mary’s adjusted gross income? $ ____________

b. What is the amount of their itemized deductions or standard deduction? $ ____________

c. What is their 2004 taxable income? $ ____________

3. Leslie is a single taxpayer who is under age 65 and in good health. For 2004, shehas a salary of $23,000 and itemized deductions of $1,000. Leslie is entitled to oneexemption on her tax return.a. How much is Leslie’s adjusted gross income? $ ____________b. What amount of itemized or standard deduction(s)

should she claim? $ ____________c. What is the amount of Leslie’s taxable income? $ ____________

4. For each of the following situations, indicate whether the taxpayer(s) is requiredto file a tax return for 2004. Explain your answer.a. Helen is a single taxpayer with wages in 2004 of $7,150.

____________________________________________________________________________________________________________________________________________________________________________________________________________

b. Joan is a single college student who is claimed as a dependent by her parents. She earned $1,550 from a part-time job and has $1,150 in interest income.____________________________________________________________________________________________________________________________________________________________________________________________________________

c. Leslie (age 64) and Mark (age 66) are married and file a joint return. They received $16,300 in interest income from a savings account.____________________________________________________________________________________________________________________________________________________________________________________________________________

d. Ray (age 60) and Jean (age 57) are married and file a joint tax return. They had $14,700 in earnings from wages and $5,000 in “tax-free” interest income.____________________________________________________________________________________________________________________________________________________________________________________________________________

e. Harry, a 19-year-old single taxpayer, had net earnings from self-employment of $1,500.____________________________________________________________________________________________________________________________________________________________________________________________________________

5. Geri waits tables in a La Jolla restaurant. Geri received $1,200 in unreported tips during 2004 and owes Social Security taxes on these tips. Her total income for the year, including the tips, is $4,300. Is Geri required to file an income taxreturn for 2004?

____________Why?________________________________________________________________________________________________________________________________________________________________________________________________________


6. Diego, age 28, married Dolores, age 27, during 2004. Their salaries for the yearamounted to $46,479 and they had interest income of $3,500. Diego and Dolores’sdeductions for adjusted gross income amounted to $1,900, their itemized deduc-tions were $10,172, and they claimed two exemptions on their return.a. What is the amount of their adjusted gross income? $ ____________b. What is the amount of their itemized deductions or

standard deduction? $ ____________c. What is the amount of their taxable income? $ ____________d. What is their tax liability for 2004? $ ____________

7. For each of the following cases, indicate the taxpayer(s) filing status for 2004 usingthe following legend.

A – Single D – Head of householdB – Married, filing a joint return E – Qualifying widow(er)C – Married, filing separate returns

FilingCase Status

a. Linda is single and she supports her mother, including payingall the costs of her housing in an apartment across town. ____________

b. Frank is single and he has a dependent child living in his home. ____________

c. Arthur is single and he supports his brother, who lives in his own home. ____________

d. Leslie ’s final decree of divorce was granted on June 18, 2004. She has no dependents. ____________

e. Tom and Carry were married on December 31, 2004. ____________

8. Determine from the tax table in Appendix A the amount of the income tax foreach of the following taxpayers for 2004.

Taxpayer(s) Filing Status Taxable Income Income TaxAllen Single $21,000 $ ____________Boyd MFS 24,545 $ ____________Caldwell MFJ 35,784 $ ____________Dell H of H 27,450 $ ____________Evans Single 45,000 $ ____________

9. Indicate, in each of the following situations, the number of exemptions the taxpay-ers are entitled to claim on their 2004 income tax returns.

Number ofExemptions

a. Donna, a 20-year-old single taxpayer, supports her mother, who lives in her own home. Her mother has income of $1,350. ____________

b. William, age 43, and Mary, age 45, are married and support William’s 19-year-old sister, who is not a student. The sister’sincome from a part-time job is $3,500. ____________

c. Devi was divorced in 2004 and receives child support of $250 per month from her ex-husband for the support of their son, John who lives with her. Devi is 45. ____________

d. Wendell, an 89-year-old single taxpayer, supports his son, who is 67 years old. ____________

e. Wilma, age 65, and Morris, age 66, are married. They file a joint return. ____________


10. Ulysses and Penelope are married and file separate returns for 2004. Penelopeitemizes her deductions on her return. Ulysses’ adjusted gross income was $17,400, his itemized deductions were $2,250, and he is entitled to one exemption. Calculate Ulysses’ income tax liability.

$ ____________

11. Alicia (age 18) is a full-time single college student who is supported by her par-ents. She earns $5,500 from a part-time job and has taxable interest income of$1,400. Her itemized deductions are $690. Calculate Alicia’s tax liability for 2004.

$ ____________

12. Jim (age 50) and Martha (age 49) are married with three dependent children.They file a joint return for 2004. Their income from salaries totals $130,000 andthey received $10,000 in taxable interest, $5,000 in royalties and $3,000 of otherordinary income. Jim and Martha’s deductions for adjusted gross income amountto $3,200, and they have itemized deductions totalling $10,000, consisting of$7,500 in state income taxes and $2,500 in investment interest expense. Calcu-late the following amounts.a. Gross income $ ____________b. Adjusted gross income $ ____________c. Itemized deduction or standard deduction amount $ ____________d. Number of exemptions $ ____________e. Taxable income $ ____________f. Income tax liability $ ____________

13. Frank, age 35, and Joyce, age 34, are married and file a joint income tax return for 2004. Their salaries for the year total $180,000 and they have taxable interestincome of $40,000. They have no deductions for adjusted gross income. Theiritemized deductions of $12,000 consist of $4,000 in state income taxes, $5,000 ofcharitable contributions and a $3,000 casualty loss deduction (after consideringthe $100 floor and the 10 percent of adjusted gross income limitation). Frank andJoyce do not have any dependents.a. What is the amount of their adjusted gross income? $ ____________b. What is their deduction for personal exemptions? $ ____________c. What is the amount of their taxable income? $ ____________

14. In 2004, Lou has a salary of $54,000 from her job. She also has interest income of$1,700. Lou is single and has no dependents. During the year Lou sold silver coinsheld as an investment for a $7,000 loss. Calculate the following amounts for Lou.a. Adjusted gross income $ ____________b. Standard deduction $ ____________c. Exemption $ ____________d. Taxable income $ ____________

15. Go to the IRS Web site (http://www.irs.gov) select “The Newsroom” and note thename of the most recent news release.

16. Go to the IRS Web site (http://www.irs.gov) and print out a copy of the mostrecent Schedule F of Form 1040.

17. Go to the IRS Web site (http://www.irs.gov) and print out a copy of the mostrecent Instructions for Schedule R of Form 1040.

www

www

www


18. Go to Will Yancey’s home page (http://www.willyancey.com) and give the com-plete Web address for each of the following sites:a. The California Franchise Tax Board.b. The New York Department of Taxation and Finance.c. The American Institute of CPAs home page (AICPA).

19. Go to the Practitioner’s Publishing Co. Web site (http://www.ppcnet.com), selectthe “News & Views” tab, and then the 5-minute Tax Briefing. Locate the mostrecent Practitioners Tax Action Bulletin. Print out a copy of the bulletin.

GROUP 3:COMPREHENSIVE PROBLEMS

1. Patty Bayan is a single taxpayer living at 543 Space Drive, Houston, TX 77099. HerSocial Security number is 466-33-1234. For 2004, Patty has no dependents, and herW-2 from her job at a local restaurant where she parks cars contains the followinginformation:

Wages $19,400Withholding (Federal income tax) 3,000FICA tax 1,484These wages are Patty’s only income for 2004, and she wishes to donate to the

Presidential Election Campaign Fund.Required: Complete Form 1040EZ on page 1-33 for Patty Bayan for the 2004 taxyear.

2. Leslie and Leon Lazo are married and file a joint return for 2004. Leslie’s SocialSecurity number is 466-47-3311 and Leon’s is 467-74-4451. They live at 143Snapdragon Drive, Reno, Nevada, 82102. For 2004, Leslie did not work, andLeon’s W-2 from his butcher’s job showed the following:

Wages $35,500Withholding (Federal income tax) 4,600FICA tax 2,716Leslie and Leon have an 18-year-old son named Lyle (Social Security number

552-52-5552), who is a dependent, a full-time student, and does not qualify for thechild tax credit due to his age.Required: Complete Form 1040A on page 1-35 for Leslie and Leon for the 2004tax year.

GROUP 4:TEAM PROJECT

Dr. Ivan I. Incisor and his wife Irene are married and file a joint return for 2004. Ivan’sSocial Security number is 477-34-4321 and he is 48 years old. Irene I. Incisor’s SocialSecurity number is 637-34-4927 and she is 45 years old. They live at 468 Mule Deer Lane,Spokane, Washington, 99206.

Dr. Incisor is a dentist and his 2004 Form W-2 from his job at Bitewing Dental Clinic,Inc. showed the following:

Wages $150,000Withholding (Federal income tax) 28,500

The Incisor’s have a 12-year-old son, Ira, who is enrolled in the seventh grade at thePerpetual Perpetuity School. Ira’s Social Security number is 690-99-9999. The Incisor’s

www

www


also have an 18-year-old daughter, Iris, who is a part-time freshman student at Snow MassCommunity College (SMCC). Iris’s Social Security number is 899-99-9999. Iris is marriedto Sean Slacker (SS No. 896-33-0954), who is 19 years-old and a part-time student atSMCC. Sean and Iris have a 1-year-old child, Seth Slacker (SS No. 648-99-4306). Sean,Iris and Seth all live with Ivan and Irene during the entire current calendar year. Seanand Iris both work for Sean’s wealthy grandfather as apprentices in his business. Theirwages for the year were a combined $50,000 which allowed them to pay all the personalexpenses for themselves and their son, except Ivan and Irene let them live at their housefor free.

Ivan and Irene have savings account interest income of $1,380 from the PacificNorthwest Bank.

Ira is eligible for the Child Credit discussed in Chapter 6, but the Incisors can notclaim the credit since their income is too high.

Required: Use a computer software package to complete Form 1040 for Ivan and IreneIncisor for 2004. Be sure to save your data input files since this case will be expandedwith more tax information in later chapters. Make assumptions regarding any informa-tion not given.


Draft as o

f

2/04/2004Do you, or your spouse if a joint return, want $3 to go to this fund? �

Taxable interest. If the total is over $1,500, you cannot use Form 1040EZ.

Department of the Treasury—Internal Revenue ServiceForm Income Tax Return for Single and

Joint Filers With No Dependents1040EZ 2004 OMB No. 1545-0675

Note. Checking “Yes” will not change your tax or reduce your refund.

PresidentialElectionCampaign(page 12)

Wages, salaries, and tips. This should be shown in box 1 of your Form(s) W-2.Attach your Form(s) W-2.

11

AttachForm(s) W-2here.Enclose, butdo not attach,any payment.

2 2

Add lines 1, 2, and 3. This is your adjusted gross income.

Can your parents (or someone else) claim you on their return?5Note. Youmust checkYes or No.

Yes. No.

5

Subtract line 5 from line 4. If line 5 is larger than line 4, enter -0-.This is your taxable income. �

66

Paymentsand tax

Earned income credit (EIC).

7 7

Tax. Use the amount on line 6 above to find your tax in the tax table on pages24–28 of the booklet. Then, enter the tax from the table on this line.

1010

Refund11a 11a

If line 10 is larger than line 9, subtract line 9 from line 10. This isthe amount you owe. For details on how to pay, see page 20. �

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 23.

Income

Cat. No. 11329W

�44

1212

Add lines 7 and 8. These are your total payments. �

8 8

9 9

Federal income tax withheld from box 2 of your Form(s) W-2.

Unemployment compensation and Alaska Permanent Fund dividends(see page 14).

33

Amountyou owe

b Routing number

Account number

c Type: Checking

Enter amount fromworksheet on back.

If single, enter $7,950.If married filing jointly, enter $15,900.See back for explanation.

Have it directlydeposited! Seepage 19 and fillin 11b, 11c,and 11d.

d�

�

Form 1040EZ (2004)

(99)

NoYes YesNo

SpouseYou

Savings

Under penalties of perjury, I declare that I have examined this return, and to the best of my knowledge and belief, it is true, correct, andaccurately lists all amounts and sources of income I received during the tax year. Declaration of preparer (other than the taxpayer) is basedon all information of which the preparer has any knowledge.

Signhere

DateYour signature

Keep a copyfor yourrecords.

DateSpouse’s signature. If a joint return, both must sign.

Preparer’s SSN or PTINDatePreparer’ssignature

Check ifself-employed

Paidpreparer’suse only

Firm’s name (oryours if self-employed),address, and ZIP code

EIN

Phone no.

��

�

Your occupationJoint return?See page 11.

Daytime phone number

( )

Spouse’s occupation

( )

Designee’sname �

Do you want to allow another person to discuss this return with the IRS (see page 20)?Third partydesignee Phone

no. � ( )

Yes. Complete the following. No

Personal identificationnumber (PIN) �

Your social security numberLast nameYour first name and initial

LABEL

HERE

Spouse’s social security numberLast nameIf a joint return, spouse’s first name and initial

Home address (number and street). If you have a P.O. box, see page 12. Apt. no.

You must enter yourSSN(s) above.

City, town or post office, state, and ZIP code. If you have a foreign address, see page 12.

�Important!�

�

Label(See page 12.)Use the IRSlabel.Otherwise,please printor type.

�

If line 9 is larger than line 10, subtract line 10 from line 9. This is your refund. �


Draft as of

09/14/2004 Head of household (with qualifying person). (See page 19.)If the qualifying person is a child but not your dependent,enter this child’s name here. �Married filing separately. Enter spouse’s SSN above and

full name here. �

Department of the Treasury—Internal Revenue ServiceForm

U.S. Individual Income Tax Return1040A 2004OMB No. 1545-0085

Your social security number

Last nameYour first name and initialLabel

LABEL

HERE

(See page 17.)

Spouse’s social security numberLast nameIf a joint return, spouse’s first name and initial

Use theIRS label. Home address (number and street). If you have a P.O. box, see page 18. Apt. no.

You must enter yourSSN(s) above.

City, town or post office, state, and ZIP code. If you have a foreign address, see page 20.

Filingstatus

Boxeschecked on6a and 6b

Yourself. If someone can claim you as a dependent, do not checkbox 6a.

6aExemptions

Spouseb No. of childrenon 6c who:(4) if qualifying

child for childtax credit (see

page 21)

(2) Dependent’s socialsecurity number

c● lived withyou

● did not livewith you dueto divorce orseparation(see page 20)

If more than sixdependents,see page 19.

Dependentson 6c notentered above

dAdd numberson linesabove �Total number of exemptions claimed.

Wages, salaries, tips, etc. Attach Form(s) W-2.7 7

Taxable interest. Attach Schedule 1 if required.8a 8a8bTax-exempt interest. Do not include on line 8a.b

AttachForm(s) W-2here. AlsoattachForm(s)1099-R if taxwas withheld.

Ordinary dividends. Attach Schedule 1 if required.9a 9a

IRAdistributions.

11a Taxable amount(see page 23).

11b

Enclose, but donot attach, anypayment.

11a 11bTaxable amount(see page 24).

12b12a Pensions andannuities. 12b12a

13 Unemployment compensation and Alaska Permanent Fund dividends. 1314a Taxable amount

(see page 25).Social securitybenefits.

14b14b14a

Add lines 7 through 14b (far right column). This is your total income. �15 15

IRA deduction (see page 26).17 17Student loan interest deduction (see page 29).

Income

18

Add lines 16 through 19. These are your total adjustments. 20

Subtract line 20 from line 15. This is your adjusted gross income. �

18

21

Dependents:

�Check onlyone box.

If you did notget a W-2, seepage 22.

Form 1040A (2004)

IRS Use Only—Do not write or staple in this space.

(3) Dependent’srelationship to

you(1) First name Last name

20

21

Adjustedgross income

�Important!�

Cat. No. 11327A

Otherwise,please printor type.

For Disclosure, Privacy Act, and Paperwork Reduction Act Notice, see page 56.

(99)

Capital gain distributions (see page 23). 1010

PresidentialElection Campaign(See page 18.) � NoYes

Note. Checking “Yes” will not change your tax or reduce your refund.Do you, or your spouse if filing a joint return, want $3 to go to this fund? � YesNo

SpouseYou

Tuition and fees deduction (see page 29). 1919

1 SingleMarried filing jointly (even if only one had income)2

3Qualifying widow(er) with dependent child (see page 19)

4

5

Deduction for clean-fuel vehicles (see page 26).16 16

9bQualified dividends (see page 22).b


Draft as of

09/14/2004

If you havea qualifyingchild, attachScheduleEIC.

Single orMarried filingseparately,$4,850

30

22Enter the amount from line 21 (adjusted gross income).22

Total boxeschecked �

BlindYou were born before January 2, 1940,Checkif:

23a23aBlindSpouse was born before January 2, 1940,

b23b

If you are married filing separately and your spouse itemizesdeductions, see page 30 and check here �

Tax,credits,andpayments

24 24Subtract line 24 from line 22. If line 24 is more than line 22, enter -0-.25 25

26 If line 22 is $107,025 or less, multiply $3,100 by the total number ofexemptions claimed on line 6d. If line 22 is over $107,025, see theworksheet on page 32. 26Subtract line 26 from line 25. If line 26 is more than line 25, enter -0-.This is your taxable income. �

2727

Tax, including any alternative minimum tax (see page 31).28 28

Education credits. Attach Form 8863.31 31

3536 Subtract line 35 from line 28. If line 35 is more than line 28, enter -0-. 3637 Advance earned income credit payments from Form(s) W-2. 37

38Add lines 36 and 37. This is your total tax. �

Federal income tax withheld from Forms W-2and 1099.

3939

2004 estimated tax payments and amountapplied from 2003 return. 40

Add lines 39 through 42. These are your total payments. � 43If line 43 is more than line 38, subtract line 38 from line 43.This is the amount you overpaid.

44

45a

Refund

Amount of line 44 you want applied to your2005 estimated tax.

4646

Amount you owe. Subtract line 43 from line 38. For details on howto pay, see page 50. �

4747

48 48Estimated tax penalty (see page 50).

Under penalties of perjury, I declare that I have examined this return and accompanying schedules and statements, and to the best of myknowledge and belief, they are true, correct, and accurately list all amounts and sources of income I received during the tax year. Declarationof preparer (other than the taxpayer) is based on all information of which the preparer has any knowledge.

� �

Enter your standard deduction (see left margin).

Form 1040A (2004)

44Amount of line 44 you want refunded to you. �45a

38

Credit for child and dependent care expenses.Attach Schedule 2.

2929

Adoption credit. Attach Form 8839.

3333

Child tax credit (see page 35).32 32

Credit for the elderly or the disabled. AttachSchedule 3.

30

35 Add lines 29 through 34. These are your total credits.

40

4243

Additional child tax credit. Attach Form 8812. 42

Routingnumber

Accountnumber

Checking Savings� b c

� d

Amountyou owe

Directdeposit?See page 49and fill in45b, 45c,and 45d.

�

Earned income credit (EIC). 4141

Page 2

Form 1040A (2004)

Signhere

DateYour signature

Keep a copyfor yourrecords.

DateSpouse’s signature. If a joint return, both must sign.

Preparer’s SSN or PTINDatePreparer’ssignature

Check ifself-employed

Paidpreparer’suse only

Firm’s name (oryours if self-employed),address, and ZIP code

EIN

Phone no.

��

�

Your occupationJoint return?See page 18.

Daytime phone number

( )

Spouse’s occupation

( )

Head ofhousehold,$7,150

Married filingjointly orQualifyingwidow(er),$9,700

StandardDeductionfor—

● People whochecked anybox on line23a or 23b orwho can beclaimed as adependent,see page 30.

● All others:

Designee’sname �

Do you want to allow another person to discuss this return with the IRS (see page 51)?Third partydesignee Phone

no. � ( )

Yes. Complete the following. No

Personal identificationnumber (PIN) �

34 34

Printed on recycled paper

Retirement savings contributions credit. AttachForm 8880.

Type:

The Individual Income Tax Return

Documents

Transcript of The Individual Income Tax Return