CHAPTER 1 The Individual Income Tax Return

Income Tax Fundamentals 2013

Gerald E. Whittenburg Martha Altus-Buller

2013 Cengage Learning

Learning Objectives

Understand history/objectives of U.S. tax law Describe different entities subject to tax/reporting requirements Understand and apply tax formula Identify who must file tax returns Determine filing status & understand calculation of tax according to filing status Calculate number of exemptions and exemption amounts Calculate correct standard or itemized deduction amount for taxpayers Compute basic capital gains and losses Access and use various Internet tax resources Understand the basics of e-filing
2013 Cengage Learning

History of Taxation

Since 1913, when 16th amendment was passed, the constitutionality of income tax has never been questioned by federal courts
Income taxes serve a multitude of purposes

2013 Cengage Learning

Objectives of Tax Law

Raise revenue

Tool for social and economic policies

o

Social policy encourages desirable activities and discourages undesirable activities

Deductions for charitable contributions Credits for higher education expenses

Economic policy as manifested by fiscal policy

Encourage investment in capital assets through depreciation Credits for investment in solar and wind energy

Both economic and social

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

2013 Cengage Learning

Primary Entities/Forms

Individual
o

Taxable income includes wages, salary, selfemployment earnings, rent, interest and dividends An individual may file simplest tax form qualified for 1040EZ 1040A See next slide 1040 If error made on one of the three above forms, can amend with a 1040X
2013 Cengage Learning

Primary Entities/Forms

Individual
o

1040EZ Single or Married Filing Jointly (MFJ) Must not be 65 or older and/or blind Must not claim any dependents Taxable income must be under $100,000 Only wages, salaries, unemployment and a few others, and not more than $1,500 taxable interest income Not claim any credits other than the earned income credit
2013 Cengage Learning

Primary Entities/Forms

Individual (continued)
o

1040A Generally used by taxpayers who are not selfemployed and dont itemize deductions 1040
If

taxpayer doesnt qualify to use 1040EZ or 1040A, should complete a 1040 with possible schedules attached
Schedule A to itemize deductions Schedule B to report dividends/interest income > $1500 Schedule C to report trade/business income Schedule D to report capital gains/losses Schedule E to report rental/royalty income Schedule F to report farm/ranch activities
2013 Cengage Learning

Primary Entities/Forms

Corporations
o
o o

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

Dont pay regular corporate income taxes Instead, pass through items of income or loss to shareholders

Partnerships
o o

Reporting entity, not taxable entity 1065 reports income/loss and allocation to partners

Pass through items of income or loss to partners

2013 Cengage Learning

Tax Formula for Individuals

This formula follows Form 1040
Gross Income

less:
less: less:

Deductions for Adjusted Gross Income (AGI)

AGI Greater of Itemized or Standard Deduction Exemption(s) Taxable Income

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

less:

Tax Credits and Prepayments

Tax Due or Refund
2013 Cengage Learning

Standard Deduction and Exemptions

2012 standard deduction
Single Married Filing Joint (MFJ) Qualifying Widow(er)
also known as Surviving Spouse

$ 5,950 $11,900 $11,900

Head of Household (HOH) Married Filing Separate (MFS)

$ 8,700 $ 5,950

*Plus additional amounts for blindness or over 65: $1,150 if MFJ, MFS or qualifying widow(er) and $1,450 if HOH or Single Exemption = $3800/person
2013 Cengage Learning

Using Tax Formula

Facts: Juan (age 29) is a single taxpayer. In 2012, his salary is $39,000 and he has dividend income of $1000. In addition, he has deductions for AGI of $2,500 and $3,000 of itemized deductions. If Juan claims one exemption for this year, calculate the following amounts: Gross income Deductions for AGI ___________ ___________

Adjusted gross income

Greater of the standard deduction or itemized deductions Exemptions Taxable income

___________
___________ ___________ ___________
2013 Cengage Learning

Solution

Gross income

$40,000*

Deductions for AGI

Adjusted gross income Greater of the standard deduction or itemized deductions Exemptions Taxable income
*($39,000 + 1,000)

2,500
$37,500

5,950**
3,800 $27,750

** greater of standard ($5,590) or itemized ($3,000)

2013 Cengage Learning

Who Must File

Based on filing status and gross income

Generally, if exemptions plus greater of standard or itemized deductions exceed income, then filing is not necessary

If taxpayer is claimed as a dependent on another taxpayers return, dependents standard deduction is:

Greater of $950 or Earned income + $300 But never more than standard deduction

See Figures 1.1 and 1.2 on page 1-8

2013 Cengage Learning

Who Must File

Taxpayer must file if

o

Owe any special taxes

See

Figure 1.3 on page 1-9

o o

Had self-employment income >= $400 Other special situations as outlined on Chart C (Figure 1.3)

2013 Cengage Learning

Which Taxpayers are Required to File

Note: Must analyze each independent situation to determine if the taxpayer is required to file a return for 2012

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

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

2013 Cengage Learning

Which Taxpayers are Required to File

Simone is single (age 31) and blind and has income of $10,370; is she required to file?
No, because standard deduction = $7,400 ($5,950 + 1,450); exemption= $3,800. These amounts total to $11,200 and exceed her gross income.

2013 Cengage Learning

Which Taxpayers are Required to File

Eamon (age 67) and his wife, Roisin, (age 69) have income of $19,180 and file jointly; are they required to file? No, because standard deduction = $14,200 ($11,900 + 1,150 + 1,150); exemptions = $7,600. These amounts total to $21,800 and exceed their gross income.

2013 Cengage Learning

Which Taxpayers are Required to File

Taig is a single full time college student, age 21, with wages from a part-time job of $7,340. He is claimed as a dependent by his parents; is he required to file? Yes, because Taigs standard deduction = $5,950 and his income exceeds this amount. His exemption is 0, as hes claimed by parents.
2013 Cengage Learning

Filing Status

Single

Unmarried or legally separated as of 12/31 And not qualified as married filing separately, head of household or qualifying widow(er)

Married Filing Jointly (MFJ)

If married on 12/31 even if didnt live together entire year Same-sex couples may not file jointly If spouse dies during year you can file MFJ in current year

Married Filing Separately (MFS)

Each file separate returns Must compute taxes the same way - both itemize or both use standard
2013 Cengage If living in community property state, must follow state law Learning

Filing Status

Head of Household (HOH)

Tables have lower rates than single or MFS Taxpayer can file as HOH if:

Unmarried or abandoned as of 12/31 Paid > 50% of cost of keeping up home that was principal residence of dependent child or other qualifying dependent relative

There is one exception to principal residence requirement. If dependent is taxpayers parent, he/she doesnt have to live with taxpayer.

Note: A divorced parent who meets above rules and has signed IRS/legal document, may still claim HOH even if dependency exemption shifted to ex-spouse
2013 Cengage Learning

Filing Status

Qualifying Widow(er) with Dependent Child

o o

Also known as surviving spouse Available for two subsequent years after death of spouse
Must

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

Gets benefits of married filing joint tax rates

2013 Cengage Learning

Tax Computation
Six brackets o 10%, 15%, 25%, 28%, 33%, 35% o Tax rate schedules for different filing types
Qualifying

dividends and net long-term capital gains may be taxed at lower rates
o

Rates based on ordinary tax bracket

2013 Cengage Learning

Personal/Dependency Exemptions

Personal exemptions may be taken for self and spouse Additional exemptions may be taken for individuals who are either taxpayers

qualifying child

or

qualifying relative

For 2012 each exemption = $3,800

2013 Cengage Learning

Dependency Qualifying Child

Dependency exemption allowed when six tests met

Relationship Test - child is taxpayers child, stepchild, adopted child or taxpayers sibling, halfor step-sibling, or a descendant of any of these. Foster child may also qualify. Child must be younger than person claiming him/her, unless permanently disabled. Domicile Test- child has same principal place of abode as taxpayer for more than the year. Age Test child is under 19 or a full-time student 2013 Cengage Learning under 24 (enrolled at least 5 months of year).

Dependency Qualifying Child

Joint Return Test child doesnt file joint return with spouse (exception: if its only to claim refund, then considered to have passed this test).
Citizenship Test child is a US citizen, a resident of the US, Canada or Mexico, or an alien child adopted by and living with a US citizen. Self-Support Test child who provides more than of his/her own support cannot be claimed as a dependent of someone else. Funds received by students as scholarships are excluded from support test.
2013 Cengage Learning

What if Child Meets Dependency Requirements for More than One Taxpayer?
If one of the parties is a parent, he/she can claim If both parties are a parent, then one with whom the child resides longest can claim

If not ascertainable, parent with highest AGI may claim

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

Note: If parents are legally separated/divorced, person with whom child resides more than 6 months may claim. However, exemption can shift if custodial parent signs Form 8332 and form is attached to noncustodial parents tax return. 2013 Cengage Learning

Dependency Qualifying Relative

Dependency exemption may be granted for a qualifying relative (who is not a qualifying child) based on tests on next slide. Note: A taxpayers child who does not meet qualifying child test may meet qualifying relative test!!

2013 Cengage Learning

Dependency Qualifying Relative

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

Gross Income Test individual may not have gross income in excess of $3,800 Support Test dependent must receive over of his/her support from taxpayer Joint Return Test dependent may not file a joint return unless its solely to claim refund Citizenship Test dependent must meet the citizenship test identified in the qualifying child slide
2013 Cengage Learning

Standard Deduction
2012 standard deduction
Single Married Filing Joint (MFJ) Qualifying Widow(er)
also known as Surviving Spouse

$ 5,950 11,900 11,900

Head of Household (HOH) Married Filing Separate (MFS)

8,700 5,950

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

2013 Cengage Learning

Standard Deduction Dependents

The special rule for standard deduction for dependents is Deduction = Greater of $950 or earned income + $300, but only up to basic standard deduction Example 1: Jaime is 23 and a full time student and her parents claim her as a dependent; she earned $2,000 in 2012, how much is taxable income? $2,000 earned income (2,000) standard deduction $0 taxable income Example 2: Tia is 18 - has dividend income of $1,500 (dividends are considered unearned income), how much is taxable income? $1,500 dividend income ( 950) standard deduction $ 550 taxable income

2013 Cengage Learning

Basic Gain & Loss Model

Amount Realized*
- Adjusted Basis** Realized Gain/Loss
* Sales Price - Sales Expenses ** Cost - Accumulated Depreciation Note: Most realized gains/losses are also recognized (i.e. included in taxpayers income)
2013 Cengage Learning

Capital Gains/Losses

A capital asset is any property (personal or investment) held by a taxpayer, with certain exceptions as listed in the tax law
o

Examples: stocks, bonds, land, cars and other items held for investment Gains/losses on these assets are subject to special rates Long-term is held >12 months (taxed at capital rates see next screen) Short-term is held <= 12 months (taxed at ordinary rates)

Holding period of asset determines treatment

o

2013 Cengage Learning

Capital Gains/Losses

Long term capital gain

Special rates depending upon taxpayers bracket

Ordinary Tax Bracket 10% or 15% All other brackets Capital Gains Tax Rate 0% 15%

Long term capital loss

Only allowed $3,000 net capital loss per year against ordinary income Carry-forward any unused balance
2013 Cengage Learning

Calculating Gain/Loss
Facts: Noah purchased Sony AAA bonds in 2006 for $47,600. In 2012, he sold the bonds for $51,500, paying commission of $515. What is his: Amount realized Adjusted basis Realized gain/loss ___________ ___________ ___________

Recognized gain/loss ___________ Type of gain/loss ___________

2013 Cengage Learning

Solution
Amount realized *
Adjusted basis Realized gain/loss

$50,985
47,600 3,385

Recognized gain/loss
Type of gain/loss

3,385
Long term capital gain

*Amount realized = $51,500 515

2013 Cengage Learning

Tax and The Internet

Volumes of tax information available on internet o http://www.irs.gov contains forms and publications and a search engine to aid the user in obtaining useful information The IRS has also launched a YouTube video site and an iTunes podcast site featuring topics like how to obtain refund or file an extension Also, there are news feeds on Twitter (@IRSnews is a good source of tax info) Other good sites include www.hrblock.com and www.willyancey.com In some states, names of delinquent taxpayers posted on web sites 2013 Cengage Learning

Electronic Filing
Rules in constant transition, as IRS attempts to transition all taxpayers to e-filing Taxpayers may prepare electronic returns using own PC and tax preparation software or May utilize a paid preparer who employs e-filing

2013 Cengage Learning

The End!

2013 Cengage Learning