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3 TAX CHAPTER FORMULA AND TAX DETERMINATION; AN OVERVIEW OF PROPERTY TRANSACTIONS LECTURE NOTES TAX FORMULA COMPONENTS OF THE TAX FORMULA 1. The following formula is used to compute taxable income for individual taxpayers (see Figure 3.1 in the text ): Income (broadly conceived) Less: Exclusions Gross income Less: Deductions for adjusted gross income (AGI) Adjusted Gross Income Less: The greater of Total itemized deductions or standard deduction Less: Personal and dependency exemptions Taxable income Tax on taxable income Less: Tax credits Tax due (or refund) a. $xx,xxx (x,xxx) $xx,xxx (x,xxx) $xx,xxx (x,xxx) (x,xxx) $xx,xxx $ x,xxx (xxx) xxx Computation of tax . Once taxable income has been computed, the additional tax due to the government or the refund due to the taxpayer can be computed. Tax on taxable income (from Tax Table or Tax Rate Schedules) Credits and prepayments = Amount owed (or refund due) b. Most individuals use the Tax Table for computation of the tax. 3-1 Copyright 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. 3-2 2. 2012 Individual Income Taxes/Instructors Guide with Lecture Notes Income (broadly conceived). This includes all income of the taxpayer, both taxable and nontaxable. a. b. 3. This concept of income is essentially equivalent to gross receipts, but does not include a return of capital or a receipt of borrowed funds. Many receipts (e.g., borrowed funds) are not reported on the tax return at all. Exclusions. Congress has chosen to allow taxpayers to exclude certain items of income for various reasons (see Chapters 4 and 5 for details). Some examples are listed below. See Exhibit 3.1 in the text (Partial List of Exclusions from Gross Income) for other examples. Accident insurance proceeds Child support payments Gifts Inheritances Life insurance paid on death of insured Welfare payments Unemployment compensation (to a limited extent) 4. Gross Income. Section 61(a) of the Code defines gross income broadly as all income from whatever source derived. Some examples of gross income items are listed below. See Exhibit 3.2 in the text (Partial List of Gross Income Items) for other examples. Alimony Compensation for services Dividends Embezzled funds Gains from illegal activities Prizes Salaries Tips and gratuities 5. Deductions for Adjusted Gross Income. Included are trade or business expenses, reimbursed employee business expenses, one-half of self-employment tax paid, alimony paid, traditional IRA and Keogh contributions, forfeited interest penalty, moving expenses, capital losses, qualified interest on education loans, and other items. a. Deductions for AGI are deductible whether the taxpayer itemizes or not , while itemized deductions will benefit the taxpayer only if total itemized deductions exceed the standard deduction. CHAPTER 3 b. 6. Tax Determination, Exemptions, Property Transactions 3-3 Deductions for AGI are also designated as above-the-line deductions. This reflects that the deductions are claimed before (above-) AGI (-the-line) is reached. They are also referred to as page 1 expenses since they are reported on page 1 of Form 1040. Adjusted Gross Income. This is an important subtotal applicable to individual taxpayers, but not to corporations. It is commonly used to limit itemized deductions. Floors and ceilings are stated as a percentage of AGI. a. Floor. Casualty losses are deductible only to the extent they exceed 10% of AGI. Other examples include: (1) Medical expenses are deductible only to the extent they exceed 7.5% of AGI. See Example 4 in the text. (2) Some miscellaneous itemized deductions are deductible only if they exceed 2% of AGI. See chapters 9 and 10. b. c. 7. Ceiling. The deduction for charitable contributions may not exceed 50% of AGI. AGI is the last line of page 1 and the first line of page 2 of Form 1040. Itemized Deductions. Included are medical expenses, various (but not all) state, local, and foreign taxes, home mortgage interest, investment interest, charitable contributions, and miscellaneous expenses. a. A taxpayer should elect to itemize only if itemized deductions exceed the standard deduction (see item 14. below). b. Itemized deductions are reported on Schedule A of Form 1040. c. See Exhibit 3.3 in the text (Partial List of Itemized Deductions) for additional examples. d. Whether an expense is a deduction for or deduction from AGI may depend upon the circumstances involved. (1) Alicia pays interest on a loan obtained to purchase inventory for her furniture store. The interest is a deduction for AGI. (2) Alicia pays interest on her home mortgage. The interest is a deduction from AGI (i.e., itemized deduction). 3-4 8. 2012 Individual Income Taxes/Instructors Guide with Lecture Notes Review the list of nondeductible expenditures appearing on pp. 3-7 and 3-8 of the text. a. b. 9. Because they have no tax effect, these expenditures are not mentioned as a component of the tax formula. Also, they are not reported on tax returns (e.g., Form 1040). If an item is nondeductible, it does not matter how the related activity is classified. Thus, a speeding ticket is nondeductible whether the auto was being used on a business trip (deduction for AGI) or on a visit to a dentist (deduction from AGI). See footnote 5 in Chapter 3. Correlation of Tax Formula with Tax Form. a. At the beginning of each chapter, the text highlights the component of the tax formula to be discussed. b. The tax framework is tied to the portion of the tax return affected. (a) The tax return correlation only involves Form 1040 (i.e., the longform). Forms 1040A and 1040EZ are not included. (b) Correlation is limited to pages 1 and 2 of Form 1040references to supporting schedules (e.g., Form 2106, Schedule C) generally are not included. STANDARD DEDUCTION 10. In general. a. The standard deduction is a component of the Tax Formula see Figure 3.1. (1) (2) b. Taxpayers must choose between the standard deduction and itemizing. Reason for the standard deductionsee p. 3-9 and footnote 6. There are two types of standard deduction: basic and additional. (1) Certain individuals are not eligible. (2) Special provisions apply in determining the standard deduction available to dependents. 11. Basic Standard Deduction . The standard deduction exempts a specified amount of income from tax. The allowable standard deduction is based on the taxpayers filing status (see Table 3.1 in the text ). 12. Additional Standard Deduction . This is an additional amount allowed for taxpayers who are age 65 or older and/or blind. CHAPTER 3 a. Tax Determination, Exemptions, Property Transactions 3-5 The additional standard deduction for 2011 is $1,150 for married taxpayers and $1,450 for taxpayers who are not married (see Table 3.2 in the text ). Example: Ted, a single taxpayer who is age 66 and blind, is allowed an additional standard deduction of $2,900 ($1,450 X 2). b. 13. The additional standard deduction is allowed for the taxpayer and/or spouse. However, a taxpayer cannot claim an additional standard deduction for age or blindness of dependents. Property Tax Deduction and Auto Sales Taxes Standard Deductions (as a type of standard deduction) a. Enacted as part of the Housing and Economic Recovery Act of 2008, a new standard deduction was allowed for real estate taxes on a personal residence. b. Originally applicable for just 2008, legislation extended the provision to also include 2009. No further extension to later years occurred. c. In order to promote the sales of automobiles, ARRTA of 2009 provides a new tax incentive. The sales tax paid on the purchase can be claimed as a special standard deduction. d. The purchase had to occur from February 17 through December 31, 2009. This provision was not extended. 14. Total Standard Deduction . This is equal to the regular and additional standard deductions. Compare the taxpayers total standard deduction to itemized deductions to determine whether the taxpayer should itemize. 15. Standard Deduction Not Allowed . The standard deduction may not be claimed by the following: a married individual filing separately if either spouse itemizes; a nonresident alien; or an individual filing a short-period return due to a change in accounting period. Example: Joe and Lynn are married and file separate returns in 2011. Joe claims itemized deductions of $7,600 on his return. Lynn has itemized deductions of $1,500. Lynn must itemize and deduct $1,500, even though the standard deduction for a married person filing separately normally would be $5,800. 3-6 16. 2012 Individual Income Taxes/Instructors Guide with Lecture Notes Standard Deduction of a Dependent . The standard deduction for an individual claimed as a dependent of another taxpayer is limited to the greater of $950 or the individuals earned income + $300 (but not to exceed the amount of the basic standard deduction for the taxpayers filing status). Example: Tina, an unmarried dependent child, earns $400 on a summer job. Her standard deduction is $950 [the greater of earned income ($400) + $300 or $950 standard deduction]. Example: Ken, an unmarried dependent child, earns $1,400 on a summer job. His standard deduction is $1,700 [the greater of earned income ($1,400) + $300 or $950 standard deduction]. Example: Beth, an unmarried dependent child, earns $5,900 on a summer job. Her standard deduction is $5,800 [the greater of earned income ($5,900 + $300) or $950 standard deduction, but limited to the $5,800 maximum standard deduction]. a. Rationale: The standard deduction of a dependent is limited to negate the ability of taxpayers to shift unearned income and shelter it through use of the standard deduction. PERSONAL EXEMPTIONS 17. Exemption Amount. The exemption amount is $3,700 in 2011 ($3,650 in 2010). The amount is indexed (adjusted for inflation) each year. 18. Personal Exemption Who Qualifies . A personal exemption is generally allowed for the taxpayer (and the taxpayers spouse if a joint return is filed). a. If a separate return is filed, an exemption is allowed for a spouse only if the spouse had no gross income and was not claimed as a dependent by another taxpayer. b. For Federal tax purposes, the law does not recognize same-sex marriages. DEPENDENCY EXEMPTIONS 19. A dependent has to be either a qualifying child or a qualifying relative . a. For a comparison of the tests applicable to each category, refer to Concept Summary 31 in the text . b. Note that both categories require the satisfaction of the joint return test and the citizenship test . Qualifying Child 20. A qualifying child must satisfy six tests : CHAPTER 3 Tax Determination, Exemptions, Property Transactions Support. Relationship. Abode. Age. Joint return. 3-7 Citizenship or residency. In some situations, a child may be a qualifying child to more than one person. The tax law specifies which person has priority (see Table 3.3 in the text ). 21. Support test. The child must not be self-supporting. 22. Relationship test. a. b. 23. The relationship test includes a taxpayers child (son, daughter), adopted child, stepchild, eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of these parties (e.g., grandchild, nephew, niece). Ancestors of any of these parties (e.g., uncles, aunts, cousins) and in-laws (e.g., son-in-law, brother-in-law) are not included. Once established by marriage, the relationship survives divorce. The abode test. a. 24. Age test. a. b. c. 25. A qualifying child must live with the taxpayer for more than half of the year. Temporary absences are disregarded. A qualifying child must be under age 19 or under age 24 in the case of a student. The age test does not apply to a child who is disabled during any part of the year. An individual cannot be older than the taxpayer claiming him or her as a qualifying child. Joint return test. a. b. 26. A married person cannot be claimed as a dependent if he or she files a joint return with his or her spouse. A joint return is permissible if the filing was to recover withholdings , no tax liability would be due on separate returns , and neither spouse is required to file. Citizenship or residency tests are applicable see item 30. Below. 3-8 2012 Individual Income Taxes/Instructors Guide with Lecture Notes Qualifying Relative 27. A qualifying relative must meet a relationship test or member of the household test. a. b. Ascendants of the taxpayer (e.g., parents, grandparents), collateral relations (e.g., uncles, aunts), and in-laws are also included. c. 28. Children, siblings, and their descendants qualify. The relationship test also includes unrelated parties who live with the taxpayer (i.e., are members of the same household) Qualifying relative must meet the gross income test . a. 29. A dependents gross income must be less than the exemption amount. Gross income is determined by the income that is taxable. Qualifying relative must meet the support tests . a. Over one-half of the support of the qualifying relative must be furnished by the taxpayer. A scholarship is not included in support. b. A worksheet for determining support is contained in Table 31 located at the end of the Lecture Notes for this chapter (e.g., food, shelter, clothing, medical and dental care, and education). c. An exception to the more-than-50% test (as applied to a single taxpayer) involves the multiple support agreement. (1) Persons eligible must collectively meet the more-than-50% test. (2) To be eligible, persons must meet the relationship and more-than-10% tests. (3) Form 2120 (Multiple Support Declaration) must be used. (4) The multiple support agreement is particularly useful for adult children who are sharing in the support of parent(s). ETHICS & EQUITY Discovering Lost Dependency Exemptions (page 3-17) . By completing multiple support agreements, Jesses children can file amended returns to claim him as a dependent. The dependency exemption can be rotated among the children and need not be claimed by the same child. The year of Jesses death (i.e., 2011) can be included, as a dependent need not be alive for the whole year. However, the usual three-year statute of limitations will preclude any claims for the earlier years of the six-year period. CHAPTER 3 d. 30. Tax Determination, Exemptions, Property Transactions 3-9 An exception to the support test applies as to children of divorced or separated parents. The custodial parent is entitled to the exemption(s) unless he or she issues a waiver on Form 8332 (Release of Claim to Exemption of Child of Divorced or Separated Parents). [The noncustodial parent must attach the Form 8332 with his or her return.] Joint return test and citizenship / residency test. a. A married person cannot be claimed as a dependent if he or she files a joint return with his or her spouse. b. A joint return is permissible if the filing was to recover withholdings , no tax liability would be due on separate returns , and neither spouse is required to file. c. The dependent must be either a citizen or resident of the U.S. d. An exception is made for residents of Canada and Mexico. e. An exception is made for certain adopted children. PHASEOUT OF EXEMPTIONS 31. The phaseout is intended to reduce the benefits of personal and dependency exemptions to high bracket taxpayers. a. Since the phaseout affected higher bracket taxpayers, it is a type of stealth tax. b. There was no phaseout for 2010, but under a sunset provision, it was to be reinstated in 2011. c. TRA of 2010, however, postponed the reinstatement until January 1, 2013. . 3-10 2012 Individual Income Taxes/Instructors Guide with Lecture Notes TAX DETERMINATION FILING CONSIDERATIONS 32. Filing Requirements. The gross income level at which a taxpayer is required to file a return is generally equal to the sum of the taxpayers exemption amount plus the applicable standard deduction (see Table 3.4 in the text ). a. Exceptions to general rule : The general rule described above does not apply to a taxpayer claimed as a dependent, a married individual filing separately, or a selfemployed taxpayer. (1) A taxpayer claimed as a dependent must file: if he has earned income only and the gross income exceeds his total standard deduction; if he has unearned income only and gross income of more than $950 plus any additional standard deduction allowed; or if he has both earned and unearned income and gross income is more than the larger of earned income + $300 (but limited to the applicable standard deduction) or $950 plus any additional standard deduction allowed. (2) (3) 33. A married individual filing separately must file a return if gross income is equal to or greater than the exemption amount ($3,700 in 2011). A self-employed individual with $400 or more of net earnings from a business or profession must file a return, regardless of the amount of gross income. Additional Standard Deduction and Filing Requirements . For taxpayers age 65 or over, the additional standard deduction may or may not be considered in determining filing level requirements. a. b. The additional standard deduction for blindness is not considered in determining filing level requirements (except for those who can be claimed as dependents). c. 34. The additional standard deduction for age is considered in determining filing requirements. Additional standard deductions for age and blindness are considered in computing the filing thresholds for blind and elderly taxpayers who are claimed as dependents. Selecting the Proper Tax Form. Tax forms in order of complexity are Form 1040EZ, Form 1040A, and Form 1040. CHAPTER 3 a. Tax Determination, Exemptions, Property Transactions 3-11 Form 1040EZ is a form for taxpayers with uncomplicated tax situations. It may be used by a taxpayer who: (1) (2) has taxable income of less than $100,000; (3) has only wages, salaries, tips, taxable scholarships and fellowships, unemployment compensation, and interest income of $1,500 or less; (4) does not itemize deductions, claim any adjustments to income, claim any dependency exemptions, or claim any tax credits other than the earned income credit; and (5) b. is not age 65 or over or blind (or if married filing jointly, both spouses are not age 65 or over or blind); have a filing status of single or married filing jointly. Form 1040A is often referred to as the short form. Form 1040 (the long form) must be filed instead of Form 1040A for any of the following reasons: (1) Taxable income was $100,000 or more. (2) The taxpayer had income other than wages, salary, tips, unemployment compensation, dividends, or interest, capital gain distributions, taxable scholarship and fellowship grants, pensions, annuities, IRAs, and taxable Social Security benefits. (3) Adjustments to income other than educator expenses, IRA deduction, student loan interest deduction, and tuition and fees deduction. (4) Tax credits claimed other than child tax credit, additional child tax credit, education credits, earned income credit, credit for child and dependent care expenses, credit for the elderly or the disabled, adoption credit, and retirement savings contributions credit. (5) The taxpayer does not use the standard deduction, but chooses to itemize deductions from AGI. (6) The taxpayer was required to use the Tax Rate Schedules. FILING STATUS 35. Determination of the proper filing status is very important. The tax rates are lowest for married taxpayers filing jointly and are highest for married taxpayers filing separately. 36. Rates for Single Taxpayers . The rates for single taxpayers apply to taxpayers who are unmarried or separated under a decree of divorce or separate maintenance. 3-12 2012 Individual Income Taxes/Instructors Guide with Lecture Notes a. b. 37. The rates for single taxpayers do not apply to a taxpayer who qualifies for another filing status (i.e., married, head of household, or surviving spouse). Marital status is determined on the last day of the taxable year , or as of the date of death if one spouse dies during the year. State law governs marital status . Rates for Married Individuals . To qualify to file a joint return, a couple must be married as of the end of the taxable year . a. Due to the tax rate structure and differential standard deduction amounts, there could develop a penalty tax for being married. (1) The marriage penalty materialized when both spouses worked and earned more than modest incomes. When their earnings were combined on a joint return, the result placed them in a higher tax bracket than if they were single, filing individually. (2) The penalty could also develop when both working spouses had low incomes. b. The Tax Relief Reconciliation Act of 2001 projected a resolution of the marriage penalty : (1) c. 38. The relief would be accomplished by expanding the range of the 15% bracket and increasing the standard deduction applicable to married persons. Unfortunately, the marriage penalty has not totally disappeared. Surviving Spouse. Joint return rates apply for two years following the year of death of a spouse if the surviving spouse maintains a household which is the home of the taxpayers dependent child. a. Surviving spouse filing status is referred to by the IRS as Qualifying widow(er) with dependent child filing status. b. In the year of a spouses death , the surviving spouse can file a joint return. (1) (2) 39. However, the executor of the deceased spouses estate must consent to the filing. If not, the survivor must file as married filing separately. No problem should arise as to the joint filing where the survivor also is the executor of the deceased spouses estate. Rates for Heads of Household. Head of household rates are allowed for unmarried taxpayers who maintain a household (e.g., provide more than half the cost) for a dependent. Generally, the dependent must live in the taxpayers household for over half the year with temporary absences not counted . The dependent must satisfy either the CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-13 qualifying child or qualifying relative criteria. For head-of-household purposes, a qualifying relative must also meet relationship the test. a. An unmarried qualifying child who is not a dependent can qualify a taxpayer for head of household filing status. b. A taxpayers parents need not live in the taxpayers household if at least one parent qualifies as a dependent of the taxpayer. c. Very often, a surviving spouse will qualify as head of household when the twoyear surviving spouse status terminates. ETHICS & EQUITY Temporary or Permanent Absence (page 3-27). Presuming Minerva still meets the support test, claiming Luther as a dependent should not be a problem. Because he satisfies the relationship test, his absence from Minervas household makes no difference. Also, his early death in 2011 has no effect as long as he qualified as a dependent at that time. Minervas status as head of household is somewhat more problematical. Generally, qualification requires that the member live in the household for more than half of the year. However, temporary absences due to special circumstances (e.g., sickness, vacation, education) are disregarded. In such cases, however, it must be reasonable to assume that the member will return to the household. Was this true with Luther? The answer depends on the nature of his illness when he went to the medical facility for treatment. Moreover, the fact that his death was unexpected indicates that he was not terminal in an immediate sense. If, however, there was no expectation that Luther would return to Minervas household, then she should not use head of household filing status for either year. 40. Abandoned Spouse Rules. The abandoned spouse rules allow a married taxpayer to file as head of household (instead of filing separately) if the following requirements are met. a. The taxpayer cannot file a joint return with his/her spouse. b. The taxpayer must pay more than half of the cost of maintaining a household. c. The taxpayers spouse did not live in the taxpayers home during the last 6 months of the tax year. d. The taxpayers home was the principal residence of the taxpayers (natural, step, or adopted) child for more than half the year. e. The taxpayer can claim the child as a dependent. TAX DETERMINATION COMPUTATION PROCEDURE 3-14 41. 2012 Individual Income Taxes/Instructors Guide with Lecture Notes Tax Rates . The U.S. tax system is based on a progressive rate structure (i.e., a higher percentage of tax is applied as taxable income increases). a. b. The effective rate is the rate paid on total (taxable and tax-exempt) income. c. 42. The marginal rate is the highest rate applied in computing the tax. Knowledge of a taxpayers marginal tax rate is useful in tax planning situations. Knowing the marginal rate enables the tax planner to quantify the tax impact of an additional dollar of income or an additional dollar of deductions. The average rate is the rate paid on taxable income. Tax Table Method. Most taxpayers will use the Tax Table for determining their tax liability. Taxpayers who are not eligible to use the Tax Table will use the Tax Rate Schedules. a. The following taxpayers are ineligible to use the Tax Table : an individual with taxable income of $100,000 or more. 43. an individual who files a short-period return. an estate or trust. Tax Rate Schedule Method (see Table 3.5 in the text ). a. At least for the present, the rate progression of the individual income tax is: 10%, 15%, 25%, 28%, 33%, and 35%. b. With certain types of income, regular rates may be inapplicable and set rates are imposed. (1) Qualified dividends (see Chapter 4) and net long-term capital gains (see later in this chapter) are subject to a maximum rate of 15% (0% in some cases). (2) In such cases, the income tax has ceased to be progressive in effect. COMPUTATION OF NET TAXES PAYABLE OR REFUND DUE 44. Effect of Prepayments and Credits . After the tax liability is computed, prepayments and credits are subtracted to arrive at the amount of tax owed or refund due. a. Common prepayments include taxes withheld by the employer and estimated payments made by the taxpayer. CHAPTER 3 b. 45. Tax Determination, Exemptions, Property Transactions 3-15 Common credits include the earned income credit, credit for child and dependent care expenses, credit for the elderly, child tax credit, and foreign tax credit. Certain Minor Children Taxed at Parents Rate (Kiddie Tax ). Unearned income of children under age 19 or a student under age 24 is taxed at the parents rate. However, a total of $1,900 ($950 base amount + $950 standard deduction of the dependent) is exempted from taxation at the parents rate in 2011. a. The amount of net unearned income taxed at the parents rate is computed as follows: Unearned income $950 The greater of $950 or allowable itemized deductions directly connected with the production of unearned income = Net unearned income b. The childs rate applies to the childs taxable income less the amount of net unearned income taxed at the parents rate. c. If certain requirements are met (e.g., gross income is from interest and dividends only, gross income is more than $950 but less than $9,500, and no estimated tax has been paid and the child is not subject to back up withholding) concerning a dependent child under age 19, the parent may elect to report the childs unearned income on the parents tax return (Form 8814). (1) In addition to tax on the childs unearned income at the parents rate, the parent must pay an additional tax equal to the smaller of $95 or 10% of the childs gross income over $950. (2) Making the election may result in slightly more tax than if the childs income is reported separately on Form 8615. (3) As to when a taxpayer can include a childs income on his or her own tax return, see Figure 3-1 at the end of the Lecture Notes for this chapter. 3-16 2012 Individual Income Taxes/Instructors Guide with Lecture Notes GAINS AND LOSSES FROM PROPERTY TRANSACTIONS CAPITAL GAINS / LOSSES 46. Realized and Recognized Gains and Losses . Gain or loss from a property transaction is computed as follows: amount realized adjusted basis = gain (loss) realized. a. Not all realized gains are recognized (i.e., reported as taxable income in the year of realization). b. Although gains on the sale of personal use assets are generally taxable when realized, losses on the sale of personal use assets are not recognized. DEFINITION OF A CAPITAL ASSET 47. Capital Gains and Losses. Capital gains and losses result from a sale or exchange of a capital asset. 48. Capital Asset Defined. Capital assets are all assets other than (1) inventory, (2) accounts receivable arising in the course of a trade or business, (3) depreciable or real property used in a trade or business, (4) certain copyrights, etc., and (5) certain U.S. government publications. 49. Classification of Capital Gain or Loss . Sort the capital gains and losses for the year into the following classifications: 50. Short-term (held for one year or less); Long-term (held for more than one year). This includes collectibles (art, coins, stamps) that are subject to a special rate. Tax rate applicable to capital gains. a. b. Collectible long-term capital gain is subject to a rate no higher than 28%. c. Unrecaptured 1250 long-term capital gain is subject to a rate no higher than 25%. d. 51. Short-term capital gains are taxed as ordinary income. Consequently, the tax is based on the taxpayers applicable tax bracket. Other long-term capital gains are subject to a rate no higher than 15%. If the top rate falls below the 25% bracket, the alternative tax rate on long-term capital gains is 0%. The netting process takes place within each classification. Thus, long-term gains and losses are combined and short-term gains and losses are combined. CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-17 52. If the netting process results in gains and losses in different classifications, further combination is necessary. Losses are applied against the gains taxed at least favorable rates. 53. What if the end result is an overall capital loss? a. An individual taxpayer can claim up to $3,000 of a capital loss against ordinary income. b. Further, excess losses (i.e., beyond the $3,000 limit) can be carried over to future years. c. The carryover period is indefinite, and short-term losses and long term losses retain their classification. ETHICS & EQUITY A Tax Benefit from Nondependents (page 3-37) . Kristen has acted wisely. By paying the medical and dental expenses, she is able to claim them on her own return. As the expenses are quite substantial in amount and her parents are probably in a modest tax bracket, the expenses will provide Kristen with a larger tax saving. Is it proper for Kristen to deduct the expenses since she cannot claim her parents as her dependents? Under a special rule contained in 213(a), the medical expenses are allowed if the person(s) otherwise qualifies as a dependent except for the gross income and joint return tests. 3-18 2012 Individual Income Taxes/Instructors Guide with Lecture Notes Figure 3-1 Can A Taxpayer Include A Childs Income On His or Her Tax Return? Start Here Was taxpayers child under age 19 on January 1, immediately following the taxable year? No Yes Was interest and dividends the childs only income ? No Yes Was the childs income more than $950 and less than $9,500? No Yes Did the child make any estimated tax payments for the taxable year? Yes No Did the child have an overpayment of tax on his or her prior year return applied to the current year return? Yes No Was any Federal income tax withheld from the childs income (backup withholding)? Yes No Is the taxpayer the parent whose return must be used? No Yes Tax payer can include the childs income on his or her tax return by completing Form 8814 and attaching it to the return. If this is done, child is not required to file a return. Taxpayer cannot include the childs income on his or her return. CHAPTER 3 Table 3-1 Tax Determination, Exemptions, Property Transactions 3-19 Worksheet for Determining Support Income 1) Did the person taxpayer supported receive any income, such as wages, interest, dividends, pensions, rents, social security or welfare? (If yes, complete lines 2, 3, 4, and 5) 2) Total income received 3) Amount of income used for support 4) Amounts of income used for other purposes 5) Amount of income saved (The total of lines 3, 4, and 5 should equal line 2) Yes No $ $ $ $ Expenses for Entire Household (where the person taxpayer supported lived) 6) Lodging (Complete item a or b) a) Rent paid b) If not rented, show fair rental value of home if the person taxpayer supported owned the home, include this amount in line 20. 7) Food 8) Utilities (heat, light, water, etc. not included in line 6a or 6b) 9) Repairs (not included in line 6a or 6b) 10) Other. Do not include expenses of maintaining home, such as mortgage interest, real estate taxes, and insurance 11) Total household expenses (Add lines 6 through 10) 12) Total number of persons who lived in household $ $ $ $ $ $ $ Expenses for the Person Taxpayer Supported 13) 14) 15) 16) 17) 18) 19) 20) Each persons part of household expenses (line 11 divided by line 12) Clothing Education Medical, dental Travel, recreation Other (specify) Total cost of support for the year (Add lines 13 through 18) Amount the person provided for own support (Line 3, plus line 6b if the person taxpayer supported owned that home) 21) Amount others provided for the persons support. Include amounts provided by state, local, and other welfare societies or agencies 22) Amount the taxpayer provided for the persons support (line 19 minus lines 20 and 21) 23) 50% of line 19 $ $ $ $ $ $ $ $ $ $ $ If line 22 is more than line 23, the taxpayer meets the support test for the person. If the person meets the other dependency tests, taxpayer may claim an exemption for that person. If line 23 is more than line 22, taxpayer may still be able to claim an exemption for that person under a multiple support agreement . 3-20 2012 Individual Income Taxes/Instructors Guide with Lecture Notes SOLUTIONS TO RESEARCH PROBLEMS 1. Hoffman, Smith, and Willis, CPAs 5191 Natorp Boulevard Mason, OH 45040 March 4, 2011 Mr. Donald Dewey 4321 Mt. Vernon Road Dover, DE 19901 Dear Don: At the recent Chamber of Commerce meeting, you asked me about the tax advantages of having Van, your son, claim Debra, your daughter, as a qualifying child. If Van can treat Debra as his qualifying child, he qualifies for a dependency exemption, the child tax credit, and the earned income tax credit. On the other hand if you claim Debra, the only benefit available is a dependency exemptionyour income is too high to permit the use of either the child tax credit or earned income tax credit. A dependency exemption yields a greater tax benefit to you than to Van, but the tax saving is by far outweighed by the unavailability of the two credits. Consequently, the family would save taxes if Van claims Debra as his qualifying child. In such a case, you would have to forgo the dependency exemption for Debra. Until 2009, the procedure suggested in the preceding paragraph was permissible. However, in the Emergency Economic Stabilization Act of 2008, Congress changed the rules. Under current law, another eligible taxpayer may claim a person as a qualified child only if he or she has an adjusted gross income (AGI) higher than the highest AGI of any of the persons parents. Clearly, the new condition eliminates Van because his AGI ($16,000) is not higher than the AGI of both you and Mary. Therefore, regardless, of any willingness to waive claiming her, Debra is your qualifying child. As per our agreement, I am enclosing a statement covering the charge for my personal services. If I can be of further assistance to you in this matter, please feel free to contact me. Sincerely, William C, Dodd, CPA NOTE TO INSTRUCTOR CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-21 The relevant Code provisions are: 24 (child tax credit), 32 (earned income tax credit), 151 (dependency deduction), and 152 (dependent defined). The amendment to the Code referred to in the letter was the addition of 152(c)(4)(C). Although not called for by the facts of the problem, Van is not Dons qualifying child (because of the age test) or qualifying relative (due to the gross income test). 2. Due to the signing of Form 8332, Bernice has no recourse for 2010. She can avoid the five-year restriction by revoking the prior waiver with the filing of another Form 8332. Unfortunately, this is effective beginning with the year following the filing (i.e., 2011 in this case). She must also provide written notice of the revocation to Nate. This can be done by sending him a copy of the new Form 8332 she has filed. Presuming Bernice escapes the commitment she made on the original Form 8332 for the next four years, is she bound by the divorce decree? Not according to recently issued Reg. 1.152-4 interpreting Code 152(e). State law (including divorce proceedings) does not control how dependency exemptions are allocated for Federal income tax purposes. Under 152(e), the exemption(s) belong to the custodial parent unless that person issues a release. For divorces on or before July 2, 2008, a decree could serve as a release if it provided the same information as contained in Form 8332. The new Regulations, however, even allow such implied releases to be revoked by the custodial parent. 3-22 3. 2012 Individual Income Taxes/Instructors Guide with Lecture Notes a. Hoffman, Smith and Willis, CPAs 5191 Natorp Boulevard Mason, OH 45040 March 4, 2011 Mrs. Sophie Durbin 1310 Ash Street Kearney, NE 68849 Dear Mrs. Durbin: This letter is in response to the inquiry as to your filing status and related tax matters for tax years 2009 and 2010. According to the information provided to us, you filed for 2009 as married filing separately and are unsure as to what filing status to choose for 2010. Also, for 2009 you did not claim either your son or mother-in law as dependents. Normally, married persons who do not file a joint return must file as married filing separately. This is an unfortunate result because the tax consequences may be less desirable. There, exists, however, a special classification called abandoned spouse that allows a married person to be treated as being single. Single persons can qualify for head of household filing status. The tax rates applicable to head of household are lower than those relating to married persons filing separately. One of the requirements for being an abandoned spouse is that the taxpayer maintains a household for a child that is a dependent. The first condition you satisfy as to Ryan for all years involved. With reference to dependency status, however, age and student status makes a difference. If Ryan is 19 years or older, he cannot qualify unless he is also a student. This is the case for 2009 (and probably for 2011) but not for 2010. Thus, you are an abandoned spouse for 2009 (and probably 2011) but not for 2010. As to the dependency exemptions, your husband has no right to claim either Ryan or Isabella. You provided for their support and maintained the household in which they lived. You may claim Ryan and Isabella for 2009 and Isabella for 2010. I suggest that we prepare an amended return for you for 2009 which uses head of household rates and claims dependency deductions for both Ryan and Isabella. Not only is this proper resolution of the problem but it will save taxes. For 2010, moreover, you must use married filing separately status. You however, claim Isabella as a dependent. Please call for an appointment and I will take care of this matter and review your prospective tax status for 2011. Sincerely, B. L. Hunt, Manager b. March 4, 2011 CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-23 TAX FILE MEMO FROM: B. L. Hunt SUBJECT: Filing status of Sophie Durbin Mrs. Durbin was abandoned by her husband Karl in April 2009 and his current location remains unknown. Sophia was forced to assume the responsibility of providing support and maintenance for her son, Ryan, and her mother-in-law, Isabella. For tax year 2009, Sophia filed using married filing separately status and claimed neither Ryan nor Isabella as dependents. She has not yet filed a return for 2010 as she is uncertain of her tax status. For 2009 and under the definition of certain married persons living apart contained in 7703(b), it appears that Sophia meets the requirements for abandoned spouse. Ryan, although 19 years of age, is a qualifying child under the student exception and can be claimed as a dependent. Because Sophia is now treated as not married, she can meet the definition of head of household contained in 2(b)(1). For 2009, therefore, Sophia should file an amended return claiming Ryan and Isabella as dependents and using head of household tax rates. For 2010, the situation is different. Sophia no longer is an abandoned spouse as Ryan is not a dependent child. He is not a qualifying child (age limitation and no student exception) and he is not a qualifying relative (gross income limitation). Consequently, Sophia is married and cannot use head of household rates. She must use married filing separately rates. She can, however, claim Isabella as a dependent. If Ryan goes to college in 2011, the probability is high that Sophias tax status will revert to the way it was for tax year 2009. 3-24 4. 2012 Individual Income Taxes/Instructors Guide with Lecture Notes a. The Bakers are limited to two dependency exemptions; Florence and Darin. With regard to Janets parents, the following table summarizes the components involved. Support Provided Calvin Florence Funds spent on clothing, transportation, and recreation(1/2 of $8,000) $4,000 $4,000 Fair rental value of lodging (1/7 X $14,000) 2,000 2,000 Share of food (1/7 X $10,500) 1,500 1,500 Dental bills 1,000 Life insurance premium Parents total support $7,500 $8,500 Of Calvins total support of $7,500, the Bakers provide only $3,500 ($2,000 + $1,500), which is not more than 50%. Unfortunately, life insurance premiums are not considered to be an item of support. In Florences case, however, the Bakers furnish $4,500 ($2,000 + $1,500 + $1,000) which is more than $4,250 (50% of $8,500). As a qualifying child (under age 19), Darins income is immaterial (as long as he is not self-supporting). Since he satisfies the age requirement, his student status does not matter. Andrea is not a qualifying child as she meets neither the age or student tests. She is not a qualifying relative because the support test is not met. The facts do not state what other types of support (e.g., clothing, recreation, medical) the Bakers pay for, but it would have to be significant for the total (including room and board) to exceed $21,000. Morgan could be a qualifying child except that she appears to be selfsupporting. Furthermore, she cannot be a qualifying relative due to the support test. As was the case of Andrea, however, the facts do not reflect what other types of support (besides room and board) her parents might provide. It is unlikely that the total would exceed the $20,000 Morgan furnishes herself. b. A dependency exemption for Calvin could have been salvaged if Janet had not paid the life insurance premium. Instead, she should have applied the funds on Calvins behalf toward a support item (e.g., help pay for the vacation). Thus, Calvin could pay the premium from his own funds without jeopardizing the support percentage. In the case of Andrea, her parents would have had a better chance of meeting the support test if the cost of the car had not been so high. In this regard, could leasing, rather than purchasing, the Camaro have accomplished this result? Perhaps the Bakers could have contributed whatever portion of the cost is needed to satisfy the more than 50% requirement for the dependency exemption. CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-25 5. See the Internet Activity comment on page 2-24. 6. See the Internet Activity comment on page 2-24. 7. See the Internet Activity comment on page 2-24. 8. See the Internet Activity comment on page 2-24. 9. See the Internet Activity comment on page 2-24. NOTE See the solutions to the Comprehensive Tax Return (Appendix E in the text) problems at the end of this Instructor's Guide. ... View Full Document

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