CCH Federal Taxation Basic Principles Chapter 3 Individual Taxation An Overview

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CCH

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Chapter 3 Exhibits

1. Federal Tax Formula 2. Classification of Taxpayers 3. Filing Status 4. Computing Tax Liability 5. The Marriage Penalty 6. Effective Tax Rate vs. Marginal Tax Rate 7. Gross Income 8. Examples of “For” AGI and “From” AGI Deductions 9. Self-Employment Tax 10. Self-Employment Tax—Example 11. The Nanny Tax (for Household Employers) 12. Itemizing v. Standard Deduction CCH Federal Taxation Basic Principles Chapter 3, Exhibit Contents A 2 of 42

Chapter 3 Exhibits

13. Itemized Deductions Phaseout 14. Personal Exemptions 15. Exemptions Phaseout 16. Credits v. Deductions 17. Tax on Kiddies’ and Other Dependents’ Income 18. Dependency Exemptions—Five Tests 19. Support Test—Example 20. Criteria for Surviving Spouse and Head of Household 21. Criteria for Abandoned Spouse Chapter 3, Exhibit Contents B CCH Federal Taxation Basic Principles 3 of 42

Federal Tax Formula

Gross Income – Deductions for Adjusted Gross Income = Adjusted Gross Income – Greater of Itemized Deductions or Standard Deduction – Personal Exemptions = Taxable Income x Tax Rate = Tax Liability + Alternative Minimum Tax (if any) – Tax Credits and Prepayments + Employment Taxes (if any) = Net Tax Due or Refund CCH Federal Taxation Basic Principles Chapter 3, Exhibit 1 4 of 42

Classification of Taxpayers

Type of Return

Individual Corporation Fiduciary Partnership

Form

1040 1120 1041 1065

Filed By

Every Natural person with income of statutory minimums Corporations, including organizations taxed as corporations Trusts and estates with income in excess of statutory minimums Partnerships or joint ventures (information return only) 5 of 42 Chapter 3, Exhibit 2 CCH Federal Taxation Basic Principles

Filing Status

 Married individuals filing jointly  Married individuals filing separate returns  Single individuals  Heads of households  Surviving spouses Chapter 3, Exhibit 3 CCH Federal Taxation Basic Principles 6 of 42

Computing Tax Liability

Filing Status Single Adjusted Gross Income (AGI) $120,000 Computation of Taxable Income Standard Deduction (SD) Personal Exemption (PE) $ 4,750 $ 3,050 Taxable Income (TI) Computation of Tax Liability $ 112,200 10% x ($6,000 – $0) = $600.00

15% x ($28,400 – $6,000) = $3,360.00

27% x ($68,800 – $28,400) = $10,908.00

30% x ($112,200 – $68,800) = $13,020 Federal Tax Liability $27,888 7 of 42 Chapter 3, Exhibit 4a CCH Federal Taxation Basic Principles

Computing Tax Liability

Computation of Taxable Income Filing Status Married Filing Jointly and Surviving Spouse Adjusted Gross Income (AGI) $120,000 Standard Deduction (SD) $7,950 Personal Exemption (PE) $6,100 (2 x $3,050) Taxable Income (TI) $105,950 Computation of Tax Liability Federal Tax Liability 10% x ($12,000 – $ 0) = $1,200.00

15% x ($47,450 – $12,000) = $5,317.50

27% x ($105,950 – $47,450) = $15,795.00

$22,312.50

8 of 42 Chapter 3, Exhibit 4b CCH Federal Taxation Basic Principles

Computing Tax Liability

Filing Status Married Filing Separately Adjusted Gross Income (AGI) $120,000 Computation of Taxable Income Standard Deduction (SD) Personal Exemption (PE) Taxable Income (TI) $3,975 $3,050 $112,975 Computation of Tax Liability Federal Tax Liability 10% x ($6,000 – $0) = $600 15% x ($23,725 – $6,000) = $2,658.75

27% x ($57,325 – $23,725) = $9,072.00

30% x ($87,350 – $57,325) = $9,007.50

35% x ($112,975 – $87,350) = $8,968.75

$30,307 9 of 42 Chapter 3, Exhibit 4c CCH Federal Taxation Basic Principles

Computing Tax Liability

Filing Status Head of Household Adjusted Gross Income (AGI) $120,000 Computation of Taxable Income Standard Deduction (SD) Personal Exemption (PE) $7,000 $3,050 Taxable Income (TI) $109,950 Computation of Tax Liability 10% x ($10,000 – $0) = $1,000.00

15% x ($38,050 – $10,000) = $4,207.50

27% x ($98,250 – $38,050) = $16,254.00

30% x ($109,950 – $98,250) = $3,510.00

Federal Tax Liability $24,971.50

10 of 42 Chapter 3, Exhibit 4d CCH Federal Taxation Basic Principles

Computing Tax Liability

Observations

 The Married Filing Jointly and Surviving Spouse rate schedules are identical.

 For

unmarried

taxpayers, the filing status creating the least amount of tax liability is

surviving spouse.

Next in the ranking is

head of household

, followed by

single

status. Special criteria must be met to qualify for surviving spouse or head of household.  Each person who cannot be claimed as a dependent is entitled to a $3,050 personal exemption deduction.

 Consider the flat tax as an alternative to the current system. Are proponents of the flat tax really championing the cause of the masses or of the wealthy? For example, joint filers with $50,000 gross income and no itemized deductions pay $4,793 or 9.6% of gross income. Who would be better off with, say, a 22% flat tax? Who would be adversely affected? Did you know that more than 70% of individual tax filers report adjusted gross income below $50,000 and claim a standard deduction?

Chapter 3, Exhibit 4e CCH Federal Taxation Basic Principles 11 of 42

The Marriage Penalty

Total Taxable Income (TI)

$120,000

Tax Computation Federal Tax Liability

Lynda and Billy are combined taxes?

single

individuals. Each earns $60,000 taxable income. What is the amount of their If Lynda and Billy marry and file jointly, what is the amount of their combined taxes assuming they have the same taxable income?

$120,000 10% x ($6,000 – $0) = $ 600.00

15% x ($28,400 – $6,000) = 3,360.00

27% x ($60,000 – $28,400) = 8,532.00

Tax on 1 single individual: $12,492.00

x 2 Tax on 2 single individuals: $24,984.00

10% x ($12,000 – $0) = $1,200.00

15% x ($47,450 – $12,000) = $5,317.50

27% x ($114,650 – $47,450) = $18,144.00

30% x ($120,000 – $114,650) = $1,605.00

$24,984 $26,266.50

MARRIAGE PENALTY $ 1,282.50

All things being equal, Lynda and Billy pay additional taxes of $1,282.50 solely because they choose to be married.

Chapter 3, Exhibit 5 CCH Federal Taxation Basic Principles 12 of 42

Effective Tax Rate vs. Marginal Tax Rate

Effective Tax Rate



Definition.

The average rate of tax paid in a tax year.



Application.

Often useful when viewed

retrospectively

(e.g., analyzing a company’s historical after-tax cash flow).

Marginal Tax Rate



Definition.

The rate of tax that would apply to additional taxable income.



Application.

Often useful when applied

prospectively

company’s expected after-tax cash flow).

(e.g., estimating a 13 of 42 Chapter 3, Exhibit 6a CCH Federal Taxation Basic Principles

Effective Tax Rate vs. Marginal Tax Rate

Example

John-Paul files as a single individual. His taxable income is $31,000 and, based on the tax rate schedule for single individuals, his federal tax liability is $4,662. What are his effective and marginal tax rates?

 

Solution

Effective tax rate = 15.0% ($4,662  $31,000).

Marginal tax rate = 27%. If John-Paul were to earn an additional $1 of taxable income, it would place him in the 27% bracket and the additional $1 would be subject to the 27% rate. (Refer to the tax brackets for single individuals.) 14 of 42 Chapter 3, Exhibit 6b CCH Federal Taxation Basic Principles

Chapter 3, Exhibit 7

Gross Income

Gross income includes all items of income from whatever source unless specifically excluded.

Examples of gross income include compensation for services, interest, rents, royalties, dividends, and annuities.

CCH Federal Taxation Basic Principles 15 of 42

Examples of “For” AGI Deductions

       Capital losses up to $3,000 Student loan interest One-half of self-employment tax Alimony (but not child support) Moving expenses Keogh and IRA deductions 100% of medical and insurance premiums for self employed taxpayers, their spouses, and dependents CCH Federal Taxation Basic Principles Chapter 3, Exhibit 8a 16 of 42

Examples of “For” AGI Deductions

 Business deductions, including:  business-use medical expenses (e.g., employee insurance premiums)  business-use state and local taxes (e.g., property tax on a warehouse)  business-use mortgage interest (e.g., interest expense on an office building mortgage)  business-use casualty losses (e.g., inventory theft losses)  all other business-use expenses (e.g., employee wages, advertising, supplies, repairs and maintenance) 17 of 42 Chapter 3, Exhibit 8b CCH Federal Taxation Basic Principles

Examples of “From” AGI Deductions

 Medical expenses  exceeding

7.5% AGI floor

 not business related  Property taxes  state and local, not federal  on principal residences, personal-use cars, stock, and other nonbusiness-use property  Income taxes  state and local, not federal  on salaries, capital gains, and other nonbusiness income 18 of 42 Chapter 3, Exhibit 8c CCH Federal Taxation Basic Principles

Examples of “From” AGI Deductions

 Interest on home mortgages (including home equity loans)  Casualty losses  exceeding

10% AGI floor

 on principal residences, personal-use cars, and other personal-use property  Charitable contributions   not to exceed

50% AGI ceiling

in certain cases, not to exceed

30% or 20% ceiling

Chapter 3, Exhibit 8d CCH Federal Taxation Basic Principles 19 of 42

Examples of “From” AGI Deductions

 Most miscellaneous itemized deductions but only the aggregate amount exceeding

2% AGI floor

Examples:  unreimbursed employee business expenses  hobby expenses (out-of-pocket and depreciation)  tax preparation fees  investment counseling fees Exception:  gambling losses are NOT subject to the 2% AGI floor Chapter 3, Exhibit 8e CCH Federal Taxation Basic Principles 20 of 42

Self-Employment Tax

The tax rate is 15.3%, made up of two parts:  an old-age, survivors, and disability insurance (OASDI) rate of 12.4%  a medicare hospital insurance (HI) rate of 2.9% Chapter 3, Exhibit 9 CCH Federal Taxation Basic Principles 21 of 42

Self-Employment Tax—Example

Computing net self-employment earnings

(a) (b) (c) = (a) – (b) (d) = (c) x 7.65% (e) = (c) – (d) Gross income from self-employment Business deductions Self-employment earnings (i.e., Schedule C amount) "Pretend" deduction Net self-employment earnings (f) (g) = $87,000 – (f) $146,000 $30,000 $146,000 – $30,000 = $116,000 $116,000 x 7.65% = $8,874 $116,000 – $8,874 = $107,126

Computing OASDI limit

Salary from employer OASDI limit, adjusted $49,300 $87,000 – $49,300 = $37,700 Chapter 3, Exhibit 10a CCH Federal Taxation Basic Principles 22 of 42

Self-Employment Tax—Example

(h) = lesser of (e) or (g) (i) (j) = (h) x (i) (k) = (e) (l) (m) = (k) x (l) (n) = (j) + (m) (o) = (n) x 1/2

Computing OASDI tax

OASDI base OASDI tax rate OASDI tax $37,700 12.4% $37,700 x 12.4% = $4,674.80

Computing Medicare tax

Net earnings Medicare tax rate Medicare tax Total FICA tax = OASDI + Medicare FICA tax deduction "for" AGI $107,126 2.9% $107,126 x 2.9% = $3,107 $4,674.80 + $3,107 = $7,781.80

$7,781.80 x 1/2 = $3,890.90

Chapter 3, Exhibit 10b CCH Federal Taxation Basic Principles 23 of 42

The Nanny Tax (for Household Employers)

What is the nanny tax?

The nanny tax is actually two types of federal tax: 1. FICA (15.3% of wages over $1,400) 2. FUT (Minimum 0.8% and maximum 6.2% on the first $7,000 of wages)

(The nanny tax does NOT include federal income tax withholdings. Household employers are not required to withhold federal income taxes unless an employee requests it and the employer agrees.)

Chapter 3, Exhibit 11a CCH Federal Taxation Basic Principles 24 of 42

The Nanny Tax (for Household Employers)

When is a taxpayer subject to the nanny tax?

The nanny tax applies to taxpayers who: 1.

Control what household work is done, how the work is performed, and when the work is performed.

(Household work includes childcare by sitters, cleaning by maids, and yard work by gardeners.)

2.

Pay cash wages in an amount greater or equal to $1,400 in 2003. (

However, FUT may be assessed on year 2002 wages paid to a “nanny” even if such wages are below $1,400. This FUT liability arises if payments in any quarter 2002 or 2003 equal or exceed $1,000. This special rule is illustrated in the example below.) Example: Fred pays his maid $1,100 in the 4th quarter of 2002 and $200 in each of the four quarters of 2003. Fred would not pay FICA tax on the maid’s wages in 2003 since $800 (i.e., $200 x 4 quarters) is less than the $1,400 minimum. However, he would have to pay FUT on year 2003 wages because $1,100 4 th quarter 2002 wages exceeded the $1,000 per quarter FUT limit.

Chapter 3, Exhibit 11b CCH Federal Taxation Basic Principles 25 of 42

Itemizing v. Standard Deduction

Itemized deductions are certain expenses of a personal nature that are specifically allowed as a deduction.

Taxpayers receive the minimum amount of itemized deductions called the standard deduction.

All taxpayers subtract the larger of their itemized deductions or the standard deduction.

26 of 42 Chapter 3, Exhibit 12 CCH Federal Taxation Basic Principles

Itemized Deductions Phaseout

 of ID’s (except “MICG”) = the lesser of (a) or (b): (a) (b) = (AGI - TH) x 3%; or = 80% of total non-MICG’s Chapter 3, Exhibit 13a CCH Federal Taxation Basic Principles 27 of 42

Itemized Deductions Phaseout Facts: “  ” This symbol means “reduction.” “ID’s” Itemized deductions.

“AGI” Adjusted gross income.

“TH” 2003

Threshold

amount of $139,500 for all filing statuses except married filing separately, which is $69,750.

“MICG” represents four itemized deductions that are never phased out: Solution: (a) (b) (c) Itemized Deduction Phaseouts—Lecture Examples: Filing status = married filing jointly (“MFJ”) AGI = $537,300.

Medical expenses = $58,297.

State income tax deduction = $7,000.

Charitable contribution deduction = $3,000.

MICG ID’s Non-MICG ID’s (AGI – TH) x 3% Medical: $58,297 – ($537,300 x 7.5%) = $18,000 $7,000 +$3,000 =$10,000 ($537,300 – $139,500) x 3% =$11,934 (d) 80% x (b) 80% x $10,000 = $8,000 I M = Medical expense deduction (i.e., in excess of 7.5% AGI).

= Investment interest deduction.

(e) = < of (c) or (d) Phaseout amount [lesser of ( c) or (d)] $8,000 is less than $11,934, therefore the phaseout amount is $8,000 C = Casualty loss deduction (i.e., in excess of 10% AGI).

(f) = (b) – (e) Adjusted Non MICG $18,000 $10,000 – $8,000 = $2,000 $ 2,000 G = Gambling loss deduction (i.e., to the extent of gambling winnings).

(g) = (a)+(f) Itemized Deduction $18,000 + $2,000 = $20,000

Abbreviations are defined on the left side of the slide.

$20,000 Chapter 3, Exhibit 13b CCH Federal Taxation Basic Principles 28 of 42

Personal Exemptions

In computing taxable income, an individual is allowed a deduction for each personal exemption allowed.

Such exemptions are (1) the exemptions for an individual taxpayer and spouse, and (2) the exemptions for dependents of the taxpayer.

No personal exemption is allowed on the return of an individual who is eligible to be claimed as a dependent on another taxpayer’s return.

29 of 42 Chapter 3, Exhibit 14 CCH Federal Taxation Basic Principles

Exemptions Phaseout %  of PDE’s = (AGI - TH)  $2,500 (or

rounded upward,

x 2, expressed as a %

$1,250 if MFS)

 where,  “%  of PDE’s” means “

percentage of personal and dependency exemptions to be reduced.

”  “TH” =

Threshold Amount

of:

Filing status:

Married filing jointly (MFJ) Surviving spouse (SS) Head of household (HH) Single (S) Married filing separately (MFS)

Example: PDE PHASEOUTS

Facts: AGI = $250,000 Filing status = MFJ.

# PDE’s = 4.

Solution: (a) (b) (AGI - TH)  2,500 Rounded upward (250,000 – 209,250)  2,500 = 16.3

16.3  17.0

2003

209,250 209,250 174,400 139,500 104,625 (c) (d) [2 x (b)]% #PDE’s x $3,000 (e) = ( c) x (d) PDE phaseout (f) = (d) – (e) PDE deduction [2 x 17.0]% = 34% 4 x 3,050 = 12,200 34% x 12,200 = 4,148 12,200 – 4,148 = 8,052 Chapter 3, Exhibit 15 CCH Federal Taxation Basic Principles 30 of 42

Credits v. Deductions

 Credit—directly reduces the tax liability.

 Deduction—reduces income to which the rate applies and indirectly reduces the tax liability.

Chapter 3, Exhibit 16 CCH Federal Taxation Basic Principles 31 of 42

Chapter 3, Exhibit 17a

Tax On Kiddies’ and Other Dependents’ Income

Legend of Abbreviations:

KIDDIES are dependent children under the age of 14.

Marginal rate = Tax rate on an additional $1 of taxable income.

AGI = Adjusted gross income.

SD = Standard deduction.

ID’s = Itemized deductions.

EI = Earned income (i.e., derived from labor).

UI = Unearned income (i.e., Non active income such as interest from bonds and dividends from stock) PE = Personal exemption.

TI = Taxable income.

Ex. = “Example” CCH Federal Taxation Basic Principles 32 of 42

Tax On Kiddies’ and Other Dependents’ Income

Formula for computing taxable income of ANY dependent, not just “kiddies,”( e.g., grandmothers):

– = – Gross income Deductions for AGI AGI Deductions from AGI – = PE = 0 Total taxable income Dependents cannot claim a PE ANY dependent’s TI Chapter 3, Exhibit 17b Earned income (“EI”) + Unearned income (“UI”) Usually 0.

The greatest of:  $750;  maximum allowable SD of $4,700;  EI + $250, limited to the

Total”

ID’s Ex. 3.24: 0+1,500 = 1,500

CCH Par. 3365 Examples:

Ex. 3.25: 800+400 = 1,200 Ex. 3.27: 1,000+2,600 =3,600 (0) (0) (0) 1,500 (750) i.e., the greatest of:  $750  $250  $0 1,200 (1,050) i.e., the greatest   of:  $750 $1,050 $0 3,600 (1,400) i.e., the   greatest of:  $750 $1,250 $1,400 (0) 750 CCH Federal Taxation Basic Principles (0) 150 (0) 2,200 33 of 42

Tax On Kiddies’ and Other Dependents’ Income -

Kiddie’s taxable income subject to parents’ marginal tax rate (“kiddie tax”):

UI 1 st Clause 2 nd Clause $750 The greater of:   $750; ID’s connected with

UI

1,500 (750) (750) 400 (750) (no need to go further) = TI subject to parents’ marginal rate 0 0 (cannot be negative)

Kiddie’s taxable income subject to kiddie’s marginal tax rate:

TI subject to Kiddie tax = Total TI -

(TI subject to Parents’ marginal rate)

800-0 = 800 150 - 0 = 150 2,600 (750) (900) 950 2,200-950 = 1,250 Chapter 3, Exhibit 17c CCH Federal Taxation Basic Principles 34 of 42

Dependency Exemptions—Five Tests

1. SUPPORT TEST. A taxpayer must provide over one-half of the amount

“actually spent”

(

NOT

“over one-half of the amount

available

for support”) on the potential dependent.

Chapter 3, Exhibit 18a CCH Federal Taxation Basic Principles 35 of 42

Dependency Exemptions—Five Tests

2. RELATIONSHIP/HOUSEHOLD TEST.

Either of the following must be satisfied.

Relationship test: Dependent must be a relative. Aunts and uncles qualify, first cousins do not.

Household test: Dependent must occupy the taxpayer’s household during the

entire year

(exceptions include birth, death, illness, education, business travel, vacation, and military service).

Chapter 3, Exhibit 18b CCH Federal Taxation Basic Principles 36 of 42

Dependency Exemptions—Five Tests

  3. GROSS INCOME TEST.  Any one of the following conditions must be present.

Dependent’s gross income < $3,050 in 2003 Dependent’s gross income  $3,050 in 2003 and dependent is both under the age of 19 and a

child

of the taxpayer Dependent’s gross income  $3,050 in 2003 and dependent is under the age of 24, a

child

of the taxpayer, and a

full-time

student.

Chapter 3, Exhibit 18c CCH Federal Taxation Basic Principles 37 of 42

Dependency Exemptions—Five Tests

4. CITIZEN OR RESIDENT ALIEN TEST. Dependent must be a citizen or national of the United States, or dependent must reside in the United States, Canada, Mexico, or American Samoa.

Chapter 3, Exhibit 18d CCH Federal Taxation Basic Principles 38 of 42

Dependency Exemptions—Five Tests

5. RETURN TEST. Dependent does not file a joint return, or dependent files a joint return solely to claim a refund.

Chapter 3, Exhibit 18e CCH Federal Taxation Basic Principles 39 of 42

Support Test—Example Facts (ignoring practical considerations):

Sources

Parents Welfare Social Security Scholarship

Total Sources

54 27 13 3

Food, Clothes, Shelter

15  10  7  0

Expenditures spent on “prospective” dependent (000’s): Medical

14 9 0 0  

Life Insurance Premium

13 0 0 0

Tuition

0 8 0 3 

Unspent

12 0 6 0 Medicare Uncle Fred 2 1 0 1  2 0 Totals 100 33 Question: Do the parents qualify for the support test?

25 Formula: YES, if qualified support from parents  total qualified support > 50% NO, if qualified support from parents  total qualified support  50% Computation: (15 + 14)  (15+14+10+9+8+7 + 1) = (29  64) = 45% < 50%,  NO 0 0 13 Chapter 3, Exhibit 19 CCH Federal Taxation Basic Principles 0 0 11 0 0 18 40 of 42

Criteria for Surviving Spouse and Head of Household Surviving Spouse (Surviving Spouse tax rates = Married Filing Jointly rate; but are < Single rates) 1. Taxpayer must be unmarried.

Head of Household (Head of household tax rates > Married Filing Jointly rate; but are < Single rates) 1. Taxpayer must be unmarried.

2. Taxpayer must furnish more than one-half of the cost of household for a

child

other relatives qualify.

or

stepchild

.

3. Child or stepchild must be a dependent. No 4. Taxpayer's household must be the principal abode for a

child

or

stepchild

for more than one-half of the year.

2. Taxpayer must furnish more than one-half the cost of household for a

relative

.

3. Unmarried child or grandchild need not be a dependent; other relatives (including married child or grandchild or unmarried foster child) must be dependents. Dependency through a

multiple support agreement

does not count.

4. Taxpayer’s household must be the principal abode for a relative for more than one-half of the year (dependent parents, however, need not live with the taxpayer).

Chapter 3, Exhibit 20 CCH Federal Taxation Basic Principles 41 of 42

Criteria for Abandoned Spouse

Abandoned spouse tax rates are the same as heads of household if four criteria are met:     Cost of household furnished by taxpayer exceeds one-half of the total cost.

Abode of the taxpayer is the abode of a dependent child over one half of the year.

Time away of “two-timer” > 6 months.

Separate return is filed.

Chapter 3, Exhibit 21 CCH Federal Taxation Basic Principles 42 of 42