CH3 Notes Tax 4011

CH3 Notes Tax 4011 - NOTES TAX FORMULA COMPONENTS OF THE...

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Unformatted text preview: NOTES TAX FORMULA COMPONENTS OF THE TAX FORMULA 1. The following formula is used to compute taxable income for individual taxpayers: Income (broadly conceived) $xx,xxx Less: Exclusions gx,xxx) Gross income $xx,xxx Less: Deductions for adjusted gross income (AGI) {x,xxx} Adjusted Gross Income $xx,xxx Less: The greater of — Total itemized deductions or standard deduction (x,xxx) Less: Personal and dependency exemptions gx,xxx) Taxable income $xx,xxx Tax on taxable income $ x,xxx Less: Tax credits gxxx) Tax due (or refund) xxx a. 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. Income gbroadly conceived). This includes all income of the taxpayer, both taxable and nontaxable. a. This concept of income is essentially equivalent to gross receipts, but does not include a return of capital or a receipt of borrowed funds. b. 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. Some examples are listed below. 4. Accident insurance proceeds Child support payments Gifts Inheritances Life insurance paid on death of insured Welfare payments Unemployment compensation (to a limited extent) 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. Alimony Compensation for services Dividends Embezzled funds Gains from illegal activities Prizes Salaries Tips and gratuities Deductions [or 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. b. 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. 9. b. C. (2) Some miscellaneous itemized deductions are deductible only if they exceed 2% of AGI. 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). Itemized deductions are reported on Schedule A of Form 1040. Whether an expense is a deduction for or deduction fiom 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 fiom AGI (i.e., itemized deduction). Nondeductible expenditures 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 fiom AGI). Correlation of Tax Formula with Tax Form. a. b. The text highlights the component of the tax formula to be discussed. The tax framework is tied to the portion of the tax return affected. (1) The tax return correlation only involves Form 1040 (i.e., “the long-form”). Forms 1040A and 1040EZ are not included. (2) Correlation is limited to pages 1 and 2 of Form 1040—references 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 (1) Taxpayers must choose between the standard deduction and itemizing. (2) Reason for the standard deduction b. There are three types of standard deduction: basic, additional, and residential property taxes. (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 taxpayer’s filing status. 12. Additional Standard Deduction. This is an additional amount allowed for taxpayers who are age 65 or older and/or blind. a. The additional standard deduction for 2011 is $1,150 for married taxpayers and $1,450 for taxpayers who are not married. Example: Ted, a single taxpayer who is age 66 and blind, is allowed an additional standard deduction of $2,800 ($1,400 X 2). b. 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. 13. Deleted 14. Total Standard Deduction. This is equal to the regular and additional standard deduction plus any other standard deduction! s). Compare the taxpayer’s 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 2009. Joe claims itemized deductions of $6,600 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 $5,700. 16. 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 individual’s earned income + $300 (but not to exceed the amount of the basic standard deduction for the taxpayer’s 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 $5,700 [the greater of earned income ($5,900 + $300) or $950 standard deduction, but limited to the $5,700 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. 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 taxpayer’s 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 gualifling relative. a. For a discussion of the tests applicable to each category, refer to the text beginning at 1] 3225 b. Note that both categories require the satisfaction of the joint return test and the citizenship test. QUALIFYING CHILD 20. A qualifying child must satisfl six tests: 0 Support. I 0 Relationship. 0 Abode. 0 Age. 0 Joint return. 0 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. 21. Support test. The child must not be self-supporting. 22. Relationship test. a. The relationship test includes a taxpayer’s 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. b. Once established by marriage, the relationship survives divorce. 23. The abode test. a. A qualifying child must live with the taxpayer for more than half of the year. Temporary absences are disregarded. 24. _A_g§ test. a. A qualifying child must be under age 19 or under age 24 in the case of a student. b. C. 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. 25. Joint return test. 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. 26. Citizenship or residency tests are applicable — see item 30. Below. QUALIFYING RELATIVE 27. A uali in relative must meet a relationship test or member of the household test. Children, siblings, and their descendants qualify. Ascendants of the taxpayer (e.g., parents, grandparents), collateral relations (e.g., uncles, aunts), and in-laws are also included. The relationship test also includes unrelated parties who live with the taxpayer (i.e., are members of the same household) 28. Qualifying relative must meet the gross income test. a. A dependent’s gross income must be less than the exemption amount. Gross income is determined by the income that is taxable. 29. 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. A worksheet for determining support is contained in Table 3—1 located at the end of these Notes (e.g., food, shelter, clothing, medical and dental care, and education). 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-S 0% 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). d. 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] 30. 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 liabilig 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 US. (1. An exception is made for residents of Canada and Mexico. e. An exception is made for certain adopted children. 3 1 . Deleted FILING THE RETURN FILING STATUS , 32. 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. 33. 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. a. 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). b. 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. 34. 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 penalg: (1) The relief would be accomplished by expanding the range of the 15% bracket and increasing the standard deduction applicable to married persons. c. Unfortunately, the marriage penalty has not totally disappeared. 35. 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 taxpayer’s 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 spouse’s death, the surviving spouse can file a joint return. (1) However, the executor of the deceased spouse’s estate must consent to the filing. If not, the survivor must file as married filing separately. (2) No problem should arise as to the joint filing where the survivor also is the executor of the deceased spouse’s estate. 36. Rates for Heads of Household. Head of household rates are allowed for unmarried taxpayers who maintain a household ge.g., provide more than half the cost) for a dependent. Generally, the dependent must live in the taxpayer’s household for over half the year with temporag absences not counted. The dependent must satisfy either the qualifying child or qualifying relative criteria. For head—of-household purposes, a qualifying relative must also meet the relationship test. a. An unmarried “ uali in ” child who is not a dependent can qualify a taxpayer for head of household filing status. A taxpayer’s parents need not live in the taxpayer’s household if at least one parent qualifies as a dependent of the taxpayer. Very often, a surviving spouse will qualify as head of household when the two- year surviving spouse status terminates. 37. 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 taxpayer’s spouse did not live in the taxpayer’s home during the last 6 months of the tax year. (1. The taxpayer’s home was the principal residence of the taxpayer’s (natural, step, or adopted) child for more than half the year. e. The taxpayer can claim the child as a dependent. FILING REQUIREMENTS 38. General Rules. The gross income level at which a taxpayer is required to file a return is generally equal to the sum of the taxpayer’s exemption amount plus the applicable standard deduction. 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 self- employed taxpayer. (l) A taxpayer claimed as a dependent must file: 0 if he has earned income only and the gross income exceeds his total standard deduction; 0 if he has unearned income only and gross income of more than $950 plus any additional standard deduction allowed; or 39. 40. (2) (3) o 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. A married individual filing separately must file a return if gross income is equal to or greater than the exemption amount $3,700. 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. The additional standard deduction for age is considered in determining filing requirements. 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. Additionalstandard 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. a. Form 1040EZ is a form for taxpayers with uncomplicated tax situations. It may be used by a taxpayer who: (1) is not age 65 or over or blind (or if married filing jointly, both spouses are not age 65 or over or blind); (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) have a filing status of single or married filing jointly. b. Form 1040A is often referred to as the “short form.” Form 1040 (the “fig 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 theTax Rate Schedules. TAX DETERMINATION—COMPUTATION PROCEDURES 41. 42. Tax Rates. The US. tax system is based on a progressive rate structure (i.e., a higher percentage of tax is applied as taxable income increases). a. The marginal rate is the highest rate applied in computing the tax. Knowledge of a taxpayer’s 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. b. The effective rate is the rate paid on total (taxable and tax-exempt) income. 0. 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: 0 an individual who files a short-period return. 43. 0 an individual with taxable income of $100,000 or more. 0 an estate or trust. Tax Rate Schedule Method. 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 and net long-term capital gains 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. 45. 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 prepaments include taxes withheld by the employer and estimated payments made by the taxpayer. b. 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 2010. 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 child’s rate applies to the child’s 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 child’s unearned income on the parent’s tax return (Form 8814). (1) In addition to tax on the child’s unearned income at the parent’s rate, the parent must pay an additional tax equal to the smaller of $95 or 10% of the child’s gross income over $950. (2) Making the election may result in slightly more tax than if the child’s income is reported separately on Form 8615. (3) As to when a taxpayer can include a child’s income on his or her own tax return, see Figure 3-1 at the end of these Notes. GAINS AND LOSSES FROM PROPERTY TRANSACTIONS — CAPITAL GAINS AND _____________—_—_———————-— 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. 48. 49. 50. Capital Gains and Losses. Capital gains and losses result from a sale or exchange of a capital asset. 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 US. government publications. Classification of Capital Gain or Loss. Sort the capital gains and losses for the year into the following classifications: 0 Short-term (held for one year or less); 0 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. 51. 52. 53. a. Short-term capital gains are taxed as ordinary income. Consequently, the tax is based on the taxpayer’s applicable tax bracket. 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. 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% for 2009. The netting process takes place within each classification. Thus, long-term gains and losses are combined and short-term gains and losses are combined. 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. 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 ordinag income. b. Further, excess losses (i.e., beyond the $3,000 limit) can be carried over to filture years. c. The cmover period is indefinite, and short-term losses and long term losses retain their classification. Figure 3-1 Can A Taxpayer Include A Child’s Income On His or Her Tax Return? Start Here Was taxpayer’s child under age 19 on January 1, immediately following the taxable year? Was interest and dividends the child’s only income ? Yes Was the child’s income more than $950 and less than $9,500? Did the child make any estimated tax payments for the taxable year? Did the child have an overpayment of tax on his or her prior year return applied to the current year return? Was any Federal income tax withheld from the child’s income (backup withholding)? Is the taxpayer the parent whose return must be used? Yes Tax payer can include the child’s income on his or her tax return by completing Form 8814 and attaching it to the return. If this is done, child is not required to file a return. Taxpayer cannot include the child’s income on his or her retum. Table 3-1 Worksheet for Determining Support Income 1) Did the person taxpayer supported receive any income, such as wages, interest, dividends, ensions rents social securi or welfare? If es com lete lines 2 3 4 and 5 Yes No 2) Total income received Simount of income used for sppmrt _4) Amounts of income used for othipupposes _5) Amount of income saved (The total of lines 3, 4, and 5 should equal line 2) Ler Expenses for Entire Household (where the person taxpayer supported lived) 6) Lodging (Complete item a or b) a) Rent paid b) If not rented, show fair rental value of home if the person taxpayer supported owned the home, include this amount in line 20. 7) Food _$ J J; 8) Utilities (heat, light, water, etc. not included in line 6a or @ $ 9 Re air_s(_not included in line 6a or 6b) $ A _L 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 Mawrsmart of household mnsegllne 11 dividmy line 12)— L I‘D—Clotm L ISflucation $ 16) Medica_l,dental $ 17) Travel, recreation _$ 18) Other (specify) $ 19) Total cost of support for the year (Add lines 13 through 18) 20) Amount the person provided for own support (Line 3, plus line 6b if the _L person taxpayer sppported owned that home) $ 21) Amount others provided for the person’s support. Include amounts provided by stawcal, and other welfare societies or agencies _$ A 22) Amount the taxpayer provided for the person’s support (line 19 minus lines 20 and 2_l)_ 23) 50% ofline 19 _L 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. ...
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CH3 Notes Tax 4011 - NOTES TAX FORMULA COMPONENTS OF THE...

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