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Chapter
14
The Individual Tax Model
Filing Status - Married
If married on the last day of the year: status must
be either Married filing joint or Married filing
separately.
MFJ rates apply to Surviving Spouse
widow or widower with a dependent child for two more
years after death of spouse.
MFS (married filing separately) rates are less
favorable than single.
Generally only used for separated couples or US citizens
or residents married to a nonresident alien
Filing Status - Unmarried
Single is the default category for unmarried
individuals (neither surviving spouse nor head of
household).
Head of household - maintain a home for either
child (need not be dependent)
dependent relative
Taxable Income Computation
Calculate total income totaling Line 22 on
1040.
Calculate Adjusted Gross Income (AGI) on
Line 37 of 1040.
Subtract the greater of:
itemized deductions or
the standard deduction
Subtract total exemptions
Result is Taxable Income
Individual Tax Model – Gross Income / Exclusions
General Rule: Gross Income is “Broadly Conceived”: Includes all income
subject to taxation unless specifically indicated as not taxable by law.
Exclusions include:
unrealized gains, gifts, inheritances, welfare type payments, many fringe
benefits, returns of capital, Municipal Interest, some US Govt for higher
education, life insurance proceeds.
Scholarships - excludible if
recipient is candidate for degree, amount received is not a payment
for services, and is used to pay tuition, books, and other similar
educational expenses
Foreign earned Income (Sec. 911) - build U.S. Economy
Exclude up to $95,100 of foreign earned income annually plus a
housing allowance (exclusion cannot exceed earned income
Individual must be a bona fide resident of the foreign country for an
entire tax year or be in the foreign country for 11 mos in any 12 month
period.
Individual Tax Model: Special Income Inclusions
Annuities: Amount not taxed: Inv. / Expected Return *
Pymts Rec
Deferred Compensation Plans: Defined Contribution
Plans, Defined Benefit Plans - Qualified Retirement Plans
Prizes and Awards - include FMV
Social Security Benefits - up 85% may be taxed
Unemployment compensation is taxable
Alimony received is taxable / Child support is not
includible but is not deductible either.
Special Rules
Dividends (cash and noncash) - FMV of prop
received (subject to E& P provisions)
Stock dividends generally not taxable
Damages - personal (special rules) business
damages not excludible.
Discharge of indebtedness - generally includible.
Business versus Investment
Business activity
Time and talent on regular basis
Profit partially attributable to personal involvement
Income is considered earned income
Hobby losses only deductible to extent of hobby income –
not a business activity
Investment activity
Passive role as owner of income-producing property
Income is considered unearned income
Losses on personal use assets are not deductible – gains
from sale are treated as capital assets.
Investments in Financial Assets
Securities include:
common and preferred stock
savings accounts, CDs, notes, bonds
Return on / Income from investment includes
Interest (ordinary income)
Dividends (special rules post May 2003)
Reinvested dividends are still taxable but increase basis.
gains (losses).
Mutual funds may report ‘distributed’ capital gains/losses.
These are still taxable but increase basis even if no cash
received.
Gains/Losses on Securities
Realization requires a sale or exchange
Gain/loss = Proceeds - adjusted basis
Character is capital - time period matters
Basis issues
reinvested dividends increase basis.
Sale of stock uses either specific ID or FIFO method of
matching basis with sales.
Mutual fund shares sold typically use an average basis.
What to do with Capital Gains and Losses
SHORT TERM asset held for <= 1 year – gains taxed as
ordinary income
LONG TERM asset held for > 1 year
L/T Gains taxed at lower capital gains tax rate of 15%
Net the gains and losses in each class (net ST, net LT, net
28%LT).
Special rule for sale of principal residence
Exclude gain on sale if home is principal residence 2 years out of 5
years ending on date of sale.
Exclude only one gain every 2 years.
Limits $500,000 MFJ, $250,000 other
Deductions for Adjusted Gross Income and AGI
Deductions for Adjusted Gross Income
Trade/Business Exp from a Sole Proprietorship are reported on Schedule C /
or for a rental property are recorded on schedule E
Student Loan interest up to $2500 (Income limits apply)
Self Employed Expenses: 50% of SE tax, percentage of health insurance
premiums, Keogh and Simple retirement plans
IRAs, Moving Expenses, Contributions to MSAs
Penalty for early withdrawal of savings
Result of Income less deductions for Adjusted Gross
Income –is AGI (very key concept) - many deductions are a
function of AGI (e.g., IRA deductions, medical expenses,
charitable contributions)
Many items of gross income are also a function of AGI
Social Security Benefits, Passive Activity Losses
Deductions from AGI: Standard Deduction or
Itemized Deductions
Standard Deduction Depends on filing status. For
2012/2013:
MFJ = $11,900/$12,200
MFS = $5,950/ 6,100
HOH = $8,700 / 8,950
Single = $5,950 / 6,100
Blind or aged (>=age 65)
MJF, MFS = additional $1,100/$1,200
HOH or Single = additional $1,400/$1,500
Take the higher of Standard Deduction or Itemized
Deductions as a reduction of AGI in the computation of
Taxable Income – Discussion of Itemized Deductions follows
Itemized Deductions / Personal Losses - Chapter 17
Itemized deductions
a special class of deductions that allow taxpayers to derive tax
benefits from certain personal & investment expenditures
Individuals deduct the greater of the standard deduction for
his/her filing status or the total of his/her itemized
deductions.
About 1/3 of all TPs claim itemized deductions
Itemized deductions are shown on Form 1040 Schedule A.
Medical Expense Deduction
Sec. 213 - qualified non-reimbursed medical expenses for a TP and
dependents qualify for a deduction subject to a 7.5% of AGI floor. (only
5% of TPs benefit)
Qualifying expenses include
Medical insurance premiums / prescription drugs
Medical treatment / Physical & Psychological treatment
medical products, glasses, artificial limbs etc.
Capital improvements - limited to excess over increase in home value
due to the improvements.
Capital improvements to remove structural barriers for physically
handicapped - fully deductible.
Cosmetic surgery if it results from disease, personal injury or
congenital defects.
No deduction allowed for:
Elective cosmetic surgery
Taxes
Sec 164 - lists deductible taxes
In general - only income taxes (other than Federal) and property taxes ad valorem taxes on investment and personal property are deductible.
Taxes must be distinguished from assessments, fines & penalties which
are not deductible.
Taxes are only deductible when they are the taxpayers obligations. No
deduction for paying another persons taxes. No deduction is someone
else pays your taxes.
50% of SE tax is deductible,
Sales tax are deductible if total is greater than income taxes paid to a
particular state.
Interest
Sec 163 - certain types of interest paid or accrued by a taxpayer during
the year is deductible
Mortgage interest, some points, home equity interest or investment
interest - are individual itemized deductions
Investment interest expense- deductible to extent of net investment
income ( Gross Inv. Inc - Inv. Exp.)
Inv. Interest deduction not allowed if used to purchase tax exempt
securities.
Qualified Residence Interest
indebtedness used to purchase, construct or improve the taxpayers
residence
2 homes allowed -Int on debt up to $1 Million is ded..
Home equity interest limited to principal of 100K
Point on new loan or improvement loan deductible when paid.
Refinancing - amortized over loan life.
Charitable Contributions
Sec 170 - gifts to qualified charities is deductible
Qualified charities: U.S. based organizations operated exclusively for religious,
charitable, scientific, literary or educational purposes or for the prevention of
cruelty to children or animals.
Contribution amount
reduced by value of any benefit received by the donor
LTCG property = value is FMV
No deduction allowed for contribution of services or rent free use of property.
Contribution Limits
LTCG property - limited to 30% of AGI
Total contributions limited to 50% of AGI
Excess contributions can be carried forward 5 years
If contributing property, TP must be able to substantiate value.
Must file form 8283 if noncash contributions > 500
Independent appraisal is required when a single item of donated property is valued in
excess of $5,000.
Casualty Losses / Miscellaneous Itemized Deductions
Casualty losses - unreimbursed losses due to theft or casualty. Losses
are reduced by $100 and 10% of AGI. Excess, if any is deductible as
an itemized deduction.
Misc. deductions subject to 2% of AGI limitation- (must exceed 2% of
AGI to be deductible)
Unreimbursed Employee Business Expenses - union dues,
uniforms, business use of auto, job search, other prof. Dues
Expenses for managing or safeguarding assets: safe deposit rental,
investment advice, investment publications
Tax determination expenses: Tax prep fees, legal representation in
tax audit, legal and accounting fees for tax planning, appraisals for
tax reporting
Misc. deductions not subject to 2% limitation
gambling losses to extent of gambling winnings
unrecovered investments in annuities due to annuitants death.
Exemptions
Personal exemption for the taxpayer (2 for MFJ).
If you are a dependent on someone else’s return, can you
still claim yourself?
Exemption = $3,800/$3,900 in 2012/2013 for each
personal or dependency exemption.
Exemptions for Dependents
Family member OR live in your home for entire
year.
You provide > 1/2 financial support
Dependent’s gross income < exemption amount
($3,650/$3,700 for 10/11)
waived for child < 19 OR student-child<24
Dependent may not generally file a joint return.
Dependent must be a U.S. citizen OR a resident of
US, Mex, Canada
Rich People
Phase-out of itemized deductions – Repealed in 2010 – likely to
return post 2012
Phase-out of exemptions – Repealed in 2010. Likely to return
post 2012
Tax Credits
A credit is a dollar for dollar reduction in the tax liability. A
deduction only reduces the tax by the marginal tax rate
associated with that deduction.
Child Credit = $1,000 per child in 2007/8. Phases out for
rich.
Dependent care credit (child < 13 years old). Credit amount
between 30% and 20% of child care costs depending on
income range.
Earned income credit. This is refundable - a transfer
payment to working poor. Increases progressivity of tax
rates. Credit is higher for taxpayers with children and phases
out as income increases.
Excess FICA withholding is refunded through a tax return
claim.
Tax Subsidies for Education
Hope scholarship credit / American job opportunity
cred - 1st 4 years of college. Max $2500 per year
per student based on tuition/fees.
Lifetime learning credit = 20% of tuition/fees: Max
$5000 per year.
Hope and Lifetime phase out begins $80,000 MFJ
Education IRA - withdrawals spend on education
are tax-free.
Payment and Filing Requirements
Taxes on wages are withheld each pay
period.
Estimated taxes are due on April 15, June
15, September 15, and January 15.
Pay 90% of current year tax, 100% of prior
year (or 110% of prior year AGI>$150,000).
Tax return due 4/15, but may be extended to
10/15 (LAST DATE).
Kiddie Tax
Children under age 18 with unearned income greater than
$1,900 are subject to kiddie tax
The unearned income in excess of $1,900 is taxed at the
parent’s highest marginal tax rate
The residual taxable income is taxed at the child’s rate.
What are the kiddie tax provisions designed to prevent?
Wealth Transfer Tax System – Covered on last
day of class.
This is an excise tax system which is
different from the income tax system.
Gift, estate, and generation skipping transfer
taxes
The unified gift and estate tax is based on
cumulative transfers over time (life + death).
Current tax rate is 35%
Gift Tax
Remember, all receipts of gifts are excluded
from INCOME taxation. We are now
discussing GIFT taxation.
Exclude $13,000 per year per donee from
taxable gifts.
No gift tax on gifts to spouse, charity, paying
tuition or medical costs.
Can treat gift by one spouse as made 1/2 by
other spouse.
Exclusion
Lifetime exclusion
$5,000,000
Income Tax Effects of Gifts
Gift is not taxable income to donee.
Donor’s adjusted basis in the property
carries over to become the donor’s basis.
exception - use FMV if less than adjusted basis
After gift, any income derived from the
property belongs to the donee.
Estate Tax
Taxed at unified estate and gift rate
schedule
FMV of estate is taxed
Unlimited marital deduction
Reduce estate by taxes, charity,
administrative expenses.
Income Tax Effect of Bequests
Receipt of a bequest is not taxable income
to heir.
Basis = FMV at date of death = free income
tax step-up in basis. (In 2010, wealthy
estates generate carryover basis).
Trade-off gift now at low basis, perhaps avoid some transfer tax
keep and include in estate, but heirs get high basis