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Unformatted text preview: chapter 8 Individual Income Tax Computation and Tax Credits Learning Objectives Upon completing this chapter, you should be able to: LO 8-1 Determine a taxpayer’s regular tax liability. LO 8-2 Compute a taxpayer’s alternative minimum tax liability. LO 8-3 Calculate a taxpayer’s employment and self-employment taxes payable. LO 8-4 Compute a taxpayer’s allowable child tax credit, child and dependent care credit, American opportunity credit, lifetime learning credit, and earned income credit. LO 8-5 Explain how to compute a taxpayer’s underpayment, late filing, and late payment penalties. Storyline Summary ©Image Source C ourtney has already determined her taxable income. Now she’s working on computing her tax liability. She Taxpayers: Courtney Wilson, age 40, and Courtney’s mother Dorothy “Gram” Weiss, age 70 Family description: Courtney is divorced with a son, Deron, age 10, and a daughter, Ellen, age 20. Gram is currently residing with Courtney. Location: Kansas City, Missouri Employment status: Courtney works as an architect for EWD. Gram is retired. Filing status: Courtney is head of household. Gram is single. Current situation: Courtney and Gram have computed their taxable income. Now they are trying to determine their tax liability, tax refund, or additional taxes due and whether they owe any payment-related penalties. knows she owes a significant amount of regular income tax on her employment and business activities. However, she’s not sure how to compute the tax on the qualified dividends she received from General Electric and is worried that she She’s planning on filing her tax return and paying may be subject to the alternative minimum tax this her taxes on time. year. Finally, Courtney knows she owes some self- Gram’s tax situation is much more straightforward. employment taxes on her business income. Courtney She needs to determine the regular income tax on her would like to determine whether she is eligible to taxable income. Her income is so low she knows she claim any tax credits, such as the child tax credit for need not worry about the alternative minimum tax, and her two children and education credits, because she she believes she doesn’t owe any self-employment tax. paid for a portion of her daughter Ellen’s tuition at Gram didn’t prepay any taxes this year, so she is con- the University of Missouri–Kansas City this year. cerned that she might be required to pay an underpay- Courtney is hoping that she has paid enough in taxes ment penalty. She also expects to file her tax return and during the year to avoid underpayment penalties. pay her taxes by the looming due date. to be continued . . . 8-1 8-2 CHAPTER 8 Individual Income Tax Computation and Tax Credits In earlier chapters we’ve learned how to compute taxable income for taxpayers such as Courtney and Gram. This chapter describes how to determine a taxpayer’s tax liability for the year. We discover that the process is not as easy as simply applying taxable income to the applicable tax rate schedule or tax table. Taxpayers may generate taxable income that is taxed at rates not provided in the tax rate schedules or tax tables. We will learn that they may also be required to pay taxes in addition to the regular income tax. We also describe tax credits taxpayers may use to reduce their gross taxes payable. We conclude the chapter by describing taxpayer filing requirements and identifying certain penalties taxpayers may be required to pay when they underpay or are late paying their taxes. We start our coverage by explaining how to compute one’s regular tax liability. LO 8-1 REGULAR FEDERAL INCOME TAX COMPUTATION Once taxpayers have determined their taxable income, they are ready to compute their gross tax from a series of progressive tax rates called a tax rate schedule. Tax Rate Schedules Congress has constructed four different tax rate schedules for individuals. The applicable tax rate schedule is determined by the taxpayer’s filing status, which we discussed in depth in the Individual Income Tax Overview, Dependents, and Filing Status chapter. Recall that a taxpayer’s filing status is one of the following: 1. 2. 3. 4. 5. Married filing jointly. Qualifying widow or widower, also referred to as surviving spouse. Married filing separately. Head of household. Single. As we described in the Introduction to Tax chapter, a tax rate schedule is composed of several ranges of income taxed at different (increasing) rates. Each separate range of income subject to a different tax rate is referred to as a tax bracket. While each filing status has its own tax rate schedule (married filing jointly and qualifying widow or widower use the same rate schedule), all tax rate schedules consist of tax brackets taxed at 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent. However, the width or range of income within each bracket varies by filing status. In general, the tax brackets are widest and higher levels of income are taxed at the lowest rates for the married filing jointly filing status, followed by the head of household filing status, single filing status, and finally, the married filing separately filing status. The tax rate schedule for each filing status is provided in Appendix D. Notice that the married filing separately schedule is the same as the married filing jointly schedule except that the taxable income levels listed in the schedule are exactly one-half the taxable income levels for married filing jointly. Example 8-1 As we determined in the Individual Deductions chapter, Courtney files under the head of household filing status and her 2018 taxable income is $145,070 (see Exhibit 6-11). What if: For now, let’s assume that all of Courtney’s income is taxed as ordinary income. That is, assume that none of her income is taxed at a preferential rate (some is, but we’ll address this in a bit). What is the tax on her taxable income? CHAPTER 8 Individual Income Tax Computation and Tax Credits 8-3 Answer: $27,715. Using the head of household tax rate schedule, her taxable income falls in the 24 percent marginal tax rate bracket, in between $82,500 and $157,500, so her tax is computed as follows: Description (1) Base tax Amount $ 12,698 (2) Income taxed at marginal tax rate 62,570 (3) Marginal tax rate 24% (4) Tax on income at marginal tax rate Tax on taxable income 15,017 $27,715 Explanation From head of household tax rate schedule for taxpayer with taxable income in 24% bracket. $145,070 – $82,500 from head of household tax rate schedule. From head of household tax rate schedule. (2) × (3) (1) + (4), rounded Example 8-2 As we determined in the Individual Deductions chapter, Gram files under the single filing status. In the Individual Deductions chapter we calculated her 2018 taxable income to be $1,990 (see Exhibit 6-13). None of her income is taxed at a preferential rate. What is the tax on her taxable income using the tax rate schedules? Answer: $199 ($1,990 × 10%) For administrative convenience and to prevent low- and middle-income taxpayers from making mathematical errors using a tax rate schedule, the IRS provides tax tables that present the gross tax for various amounts of taxable income under $100,000 and filing status (it’s impractical to provide a table for essentially unlimited amounts of income). Taxpayers with taxable income less than $100,000 generally must use the tax tables to determine their tax liability.1 Because the tax tables generate nearly the same tax as calculated from the tax rate schedule, we use the tax rate schedules throughout this chapter. Marriage Penalty or Benefit An interesting artifact of the tax rate schedules is that they can impose what some refer to as a marriage penalty, but they may actually produce a marriage benefit. A marriage penalty (benefit) occurs when, for a given level of income, a married couple incurs a greater (lesser) tax liability by using the married filing jointly tax rate schedule to determine the tax on their joint income than they would have owed (in total) if each spouse had used the single tax rate schedule to compute the tax on their individual incomes. Exhibit 8-1 explores the marriage penalty in a scenario in which both spouses earn income and another in which only one spouse earns income. As the exhibit illustrates, the marriage penalty applies to couples with two wage earners with high incomes, but a marriage benefit applies to couples with single breadwinners. For couples with two wage earners with moderate to low incomes, there is typically not a marriage penalty. Exceptions to the Basic Tax Computation In certain circumstances, taxpayers cannot completely determine their final tax liability from their tax rate schedule or tax table. Taxpayers must perform additional computations to determine their tax liability (1) when they recognize long-term capital gains or receive dividends that are taxed at preferential (lower) rates, (2) when they receive investment income subject to the net investment income tax, or (3) when the taxpayer is a child and the child’s unearned income is taxed using the trusts and estates tax rates. We describe these additional computations in detail below. Exceptions to this requirement include taxpayers subject to the kiddie tax, with qualified dividends or capital gains, or claiming the foreign-earned income exclusion. You may view the tax tables in the instructions for Form 1040 located at . 1 8-4 CHAPTER 8 Individual Income Tax Computation and Tax Credits EXHIBIT 8-1 2018 Marriage Penalty (Benefit): Two-Income vs. Single-Income Married Couple* Married Couple Taxable Income Scenario 1: Two wage earners Wife Husband $350,000 350,000 Combined $700,000 Scenario 2: One wage earner Wife Husband $700,000 0 Combined $700,000 Tax If Filing Jointly (1) Tax If Filing Single† (2) Marriage Penalty (Benefit) (1) − (2) $ 98,189.50 $ 98,189.50 $198,379 $196,379 $2,000 $224,689.50 0 $198,379 $224,689.50 $(26,310.50) *This analysis assumes the taxpayers do not owe any alternative minimum tax (discussed below). †Married couples do not actually have the option of filing as single. If they choose not to file jointly they must file as married filing separately. Preferential Tax Rates for Capital Gains and Dividends As we described in detail in the Investments chapter, certain capital gains and certain dividends are taxed at a lower or preferential tax rate relative to other types of income. In general, the preferential tax rate is 0 percent, 15 percent, or 20 percent.2 The preferential tax rates vary with the taxpayer’s taxable income. See Appendix D for the tax brackets by filing status that apply to preferentially taxed capital gains and dividends. Taxpayers with income subject to the preferential rate (long-term capital gains and qualified dividends) can use the following three-step process to determine their tax liability. Step 1: Split taxable income into the portion that is subject to the preferential rate and the portion taxed at the ordinary rates. Step 2: Compute the tax separately on each type of income. Note that the income that is not taxed at the preferential rate is taxed at the ordinary tax rates using the tax rate schedule for the taxpayer’s filing status. Step 3: Add the tax on the income subject to the preferential tax rates and the tax on the income subject to the ordinary rates. This is the taxpayer’s regular tax liability. Example 8-3 Courtney’s taxable income of $145,070 includes $700 of qualified dividends from GE (Example 5-8). What is her tax liability on her taxable income? Answer: $27,652, computed at head of household rates as follows: Description (1) Taxable income (2) Preferentially taxed income (3) Income taxed at ordinary rates Amount Explanation $145,070 Exhibit 6-11 700 $144,370 Exhibit 5-4 (1) − (2) As we discovered in the Investments chapter, some types of income may be taxed at a preferential rate of 28 percent or 25 percent. In addition, as we discuss later in this chapter, dividends and capital gains for higher income taxpayers are subject to the 3.8 percent net investment income tax. 2 CHAPTER 8 Description (4) Tax on income taxed at ordinary rates (5) Tax on preferentially taxed income Tax on taxable income Amount $ 27,546.80 105 $27,652 Individual Income Tax Computation and Tax Credits Explanation [$12,698 + ($144,370 − $82,500) × 24%] (2) × 15% [Preferential tax rate for taxpayer filing head of household with income between $51,701 and $452,400] (4) + (5), rounded In this example, what is Courtney’s tax savings from having the dividends taxed at the preferential rate rather than the ordinary rate? Answer: $63. $700 × (24% – 15%). This is the amount of the dividend times the difference in the ordinary and preferential tax rates. What if: Assume that Courtney’s taxable income is $462,400, including $15,000 of qualified dividends taxed at the preferential rate. What would be Courtney’s tax liability under these circumstances? Answer: $133,638, computed using the head of household tax rate schedule as follows: Description (1) Taxable income (2) Preferentially taxed income (3) Income taxed at ordinary rates (4) Tax on income at ordinary tax rates (5) Tax on preferentially taxed income Tax Amount Explanation $ 462,400 15,000 447,400 $ 130,888 2,750 $133,638 (1) – (2) $44,298 + [($447,400 – $200,000) × 35%] (See tax rate schedule for head of household.) [($5,000 × 15%) + ($10,000 × 20%)]* (4) + (5) *Courtney had $15,000 of preferentially taxed income. $10,000 of her dividends fall in the 20 percent preferential tax bracket ($462,400 taxable income − $452,400 end of 20 percent preferential tax bracket; see preferential tax rate schedule for head of household). The remaining $5,000 is taxed at 15 percent (15 percent bracket for preferentially taxed income extends from $51,701 to $452,400 for head of household). Net Investment Income Tax Higher-income taxpayers are required to pay a 3.8 percent tax on net investment income. For purposes of the net investment income tax, net investment income equals the sum of: 1. Gross income from interest, dividends, annuities, royalties, and rents (unless these items are derived in a trade or business to which the net investment income tax does not apply). 2. Income from a trade or business that is a passive activity or a trade or business of trading financial instruments or commodities. 3. Net gain from disposing of property (other than property held in a trade or business in which the net investment income tax does not apply).3 4. Less the allowable deductions that are allocable to items 1, 2, and 3. Tax-exempt interest, veterans’ benefits, excluded gain from the sale of a principal residence, distributions from qualified retirement plans, and any amounts subject to selfemployment tax are not subject to the net investment income tax. The tax imposed is 3.8 percent of the lesser of (1) net investment income or (2) the excess of modified adjusted gross income over $250,000 for married joint filers and surviving spouses, $125,000 for married separate filers, and $200,000 for other taxpayers. However, the income, gain, or loss attributable to invested working capital of a trade or business is subject to the net investment income tax. §1411(c)(3). 3 8-5 8-6 CHAPTER 8 Individual Income Tax Computation and Tax Credits Modified adjusted gross income equals adjusted gross income increased by income excluded under the foreign-earned income exclusion less any disallowed deductions associated with the foreign-earned income exclusion.4 Example 8-4 Courtney’s AGI (and modified AGI) is $187,000, and her investment income consists of $321 of taxable interest, $700 of dividends, and $5,000 of rental income. How much net investment income tax will Courtney owe? Answer: $0. Because Courtney’s modified AGI ($187,000) is less than the $200,000 threshold for the net investment income tax for a taxpayer filing as head of household, she will not be subject to the tax. What if: Assume that Courtney’s AGI (and modified AGI) is $225,000. How much net investment income tax will Courtney owe? Answer: $229, calculated as follows: Description (1) Net investment income Amount Explanation $ 6,021 $321 interest + $700 dividends + $5,000 rental income (2) Modified AGI 225,000 (3) Modified AGI threshold 200,000 (4) Excess modified AGI above threshold 25,000 (5) Net investment income tax base Net investment income tax 6,021 $ 229 (2) – (3) Lesser of (1) or (4) (5) × 3.8% Kiddie Tax Parents can reduce their family’s income tax bill by shifting income that would otherwise be taxed at their higher tax rates to their children whose income is taxed at lower rates. However, as we described in the Gross Income and Exclusions chapter, under the assignment of income doctrine, taxpayers cannot simply assign or transfer income to other parties. Earned income, or income from services or labor, is taxed to the person who earns it. Thus, it’s difficult for a parent to shift earned income to a child. However, unearned income or income from property such as dividends from stocks or interest from bonds is taxed to the owner of the property. Thus, a parent can shift unearned income to a child by transferring actual ownership of the incomeproducing property to the child. By transferring ownership, the parent runs the risk that the child will sell the asset or use it in a way unintended by the parent. However, this risk is relatively small for parents transferring property ownership to younger children. The tax laws reduce parents’ ability to shift unearned income to children through the so-called kiddie tax. The kiddie tax provisions apply (or potentially apply) to a child if (1) the child is under 18 years old at year-end, (2) the child is 18 at year-end but her earned income does not exceed half of her support, or (3) the child is over age 18 but under age 24 at year-end and is a full-time student during the year, and her earned income does not exceed half of her support (excluding scholarships).5 The kiddie tax does not apply to a married child filing a joint tax return or to a child without living parents. In general terms, if the kiddie tax applies, children must pay tax on a Taxpayers compute the net investment income tax using Form 8960. §1(g)(2)(A). 4 5 CHAPTER 8 Individual Income Tax Computation and Tax Credits 8-7 certain amount of their net unearned income (discussed below) at tax rates that apply to trusts and estates (see Appendix D) rather than at their own marginal tax rate.6 The kiddie tax base is the child’s net unearned income. Net unearned income is the lesser of (1) the child’s gross unearned income minus $2,1007 or (2) the child’s taxable income (the child is not taxed on more than her taxable income).8 Consequently, the kiddie tax does not apply unless the child has unearned income in excess of $2,100. Thus the kiddie tax limits, but does not eliminate, the tax benefit gained by a family unit when parents transfer income-producing assets to children. Example 8-5 What if: Suppose that during 2018, Deron received $5,100 in interest from the IBM bond, and he received another $2,200 in interest income from a money market account that his parents have been contributing to over the years. Is Deron potentially subject to the kiddie tax? Answer: Yes, Deron is younger than 18 years old at the end of the year and his net unearned income exceeds $2,100. What is Deron’s taxable income and corresponding tax liability? Answer: $6,250 taxable income and $996 tax liability, calculated as follows: Description (1) Gross income/AGI Amount $ 7,300 (2) Standard deduction (3) Taxable income 1,050 $6,250 Explanation $5,100 interest from IBM bond + $2,200 interest. All unearned income. Minimum for taxpayer claimed as a dependent on another return (no earned income, so must use minimum). See the Individual Deductions chapter. (1) – (2) (4) Gross unearned income minus $2,100 5,200 (5) Net unearned income $ 5,200 Lesser of ...
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