CHAPTER 1CHAPTER 1The Individual The Individual
Income Tax ReturnIncome Tax Return
Income Tax Fundamentals 2011
Gerald E. Whittenburg Martha Altus-Buller
2011 Cengage Learning
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Learning ObjectivesLearning Objectives Understand history/objectives of U.S. tax
law Describe different entities subject to
tax/reporting requirements Understand and apply tax formula Identify who must file tax returns and
select filing status Calculate number of exemptions and
exemption amounts Calculate standard/itemized deductions Compute basic capital gains and losses Access and use various internet tax
resources
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History of TaxationHistory of Taxation
Since 1913, when 16th amendment was passed, the constitutionality of income tax has never been questioned
Income taxes serve a multitude of purposes
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Objectives of Tax LawObjectives of Tax Law
Raise revenue
Tool for social and economic policies
◦ Social policy encourages desirable activities and discourages undesirable activities
Credits for investment in solar and wind energy
Can deduct charitable contributions
Credits for higher education expenses
◦ Economic policy as manifested by fiscal policy
Encourage investment in capital assets through depreciation
◦ Both economic and social
Exclude gain on sale of personal residence up to $250,000 ($500,000 if married)
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Primary Entities/FormsPrimary Entities/Forms
Individual◦ Taxable income includes wages, salary, self-
employment earnings, rent, interest and dividends
◦ An individual may file simplest tax form qualified for 1040EZ 1040A 1040
◦ If error made on one of the three above forms, can amend with a 1040X
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See next slide
Primary Entities/FormsPrimary Entities/Forms
Individual
◦ 1040EZ Single or Married Filing Jointly (MFJ) Must not be 65 or older and/or blind Must not claim any dependents Taxable income must be under $100,000 Only wages, salaries or unemployment and not more
than $1,500 taxable interest income Not received advance earned income credit
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Primary Entities/FormsPrimary Entities/Forms
Individual (continued)◦ 1040A
Generally used by taxpayers who are not self-employed and don’t itemize deductions
◦ 1040
If taxpayer doesn’t qualify to use 1040EZ or 1040A,should complete a 1040 with possible schedules attached Schedule A to itemize deductions Schedule B to report dividends/interest income > $1500 Schedule C to report trade/business income Schedule D to report capital gains/losses Schedule E to report rental/royalty income Schedule F to report farm/ranch activities
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Primary Entities/FormsPrimary Entities/Forms
Corporations◦ Tax rate schedule found on page 1-4◦ Corporations need to file 1120 or 1120S
◦ 1120S are for corporations that elect S Corporation status
Don’t pay regular corporate income taxes Instead, pass through items of income or loss to shareholders
Partnerships◦ Reporting entity, not taxable entity◦ 1065 – reports income/loss and allocation to partners
Pass through items of income or loss to partners
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Tax Formula for IndividualsTax Formula for Individuals
This formula follows Form 1040
Gross Income
less: Deductions for Adjusted Gross Income (AGI)
AGI
less: Greater of Itemized or Standard Deduction
less: Exemption(s)
Taxable Income
times: Tax Rate (using tax tables or rate schedules)
Gross Tax Liability
less: Tax Credits and Prepayments
Tax Due or Refund
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Standard Deduction & Standard Deduction & ExemptionsExemptions
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2010 standard deduction ($)Single 5,700
Married Filing Joint (MFJ) 11,400Qualifying Widow(er) 11,400 also known as Surviving Spouse (SS)
Head of Household (HOH) 8,400
Married Filing Separate (MFS) 5,700
*Taxpayers 65 or older and/or blind get an additional amount$1,100 if MFJ, MFS or SS$1,400 if HOH or Single
2010 exemption $3,650 – personal & dependency
Using Tax FormulaUsing Tax Formula
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Facts: Juan (age 29) is a single taxpayer. In 2010, his salary is $39,000 and he has dividend income of $1000. In addition, he has deductions for AGI of $2,500 and $3,000 of itemized deductions. If Juan claims one exemption for this year, calculate the following amounts:
Gross income ___________
Deductions for AGI ___________
Adjusted gross income ___________
Greater of the standard deduction or itemized deductions ___________Exemptions ___________
Taxable income ___________
SolutionSolution
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Gross income $40,000
Adjusted gross income ___________
Greater of the standard deduction or itemized deductions ___________
Exemptions ___________
Taxable income ___________
Gross income = $39,000 + 1,000
SolutionSolution
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Gross income $40,000
Adjusted gross income 37,500
Greater of the standard deduction or itemized deductions ___________
Exemptions ___________
Taxable income ___________
AGI = $40,000 – 2,500
SolutionSolution
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Gross income $40,000
Adjusted gross income 37,500
Greater of the standard deduction or itemized deductions 5,700
Exemptions
Taxable income ___________
The standard deduction of $5,700 exceeds itemized deductions of $3,000
Solution Solution
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Gross income $40,000
Adjusted gross income 37,500
Greater of the standard deduction or itemized deductions 5,700
Exemptions 3,650
Taxable income $28,150
Who Must FileWho Must File Based on filing status and gross income
◦ Generally, if exemptions
plus
greater of standard or itemized deductions exceed income, then filing is not necessary
◦ If taxpayer is claimed as a dependent on another taxpayer’s return, dependent’s standard deduction is: Greater of $950
or Earned income + $300 But never more than standard deduction
See Figures 1.1 and 1.2 on page 1-8
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Who Must FileWho Must File
Taxpayer must file if◦Owe any special taxes
See Figure 1.3 on page 1-9
◦Received Advanced Earned Income Credit payments from employer
◦Had self-employment income >= $400◦Other special situations as outlined on
Chart C (Figure 1.3)
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Which Taxpayers are Which Taxpayers are Required to FileRequired to File
Note: Must analyze each independent situation to determine if the taxpayer is required to file a return for 2010
Miles (age 45) is a single waiter and has unreported tips of $1,510; is he required to file?
Yes, because Miles owes social security taxes on unreported tips.
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Which Taxpayers are Which Taxpayers are Required to FileRequired to File
Simone is single (age 31) and blind and has income of $9,950; is she required to file?
No, because standard deduction = $7,100 ($5,700 + 1,400); exemption= $3,650. These amounts total to $10,750 and exceed her gross income.
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Which Taxpayers are Which Taxpayers are Required to FileRequired to File
Eamon (age 67) and his wife, Roisin, (age 69) have income of $19,180 and file jointly; are they required to file?
No, because standard deduction = $13,700 ($11,400 + 1,100 + 1,100); exemptions = $7,300. These amounts total to $20,900 and exceed their gross income.
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Which Taxpayers are Which Taxpayers are Required to FileRequired to File
Taig is a single full time college student, age 21, with wages from a part-time job of $6,340. He is claimed as a dependent by his parents; is he required to file?
Yes, because standard deduction = $5,700 and his income exceeds this amount. His exemption is 0 as he’s claimed by parents.
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Filing StatusFiling Status Single
◦ Unmarried or legally separated as of 12/31
◦ And not qualified as married filing separately, head of household or qualifying widow(er)
Married Filing Jointly (MFJ)
◦ If married on 12/31 – even if didn’t live together entire year
◦ Same-sex couples may not file jointly
◦ If spouse dies during year you can file MFJ in current year
Married Filing Separately (MFS)
◦ Each file separate returns
◦ Must compute taxes the same way - both itemize or both use standard
◦ If living in community property state, must follow state law to determine community and separate income
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Filing StatusFiling Status Head of Household (HOH)
◦ Tables have lower rates than single or MFS
◦ Taxpayer can file as HOH if: Unmarried or abandoned* as of 12/31 Paid > 50% of cost of keeping up home that was
principal residence of dependent child or other qualifying dependent relative
There is one exception to principal residence requirement. If dependent is taxpayer’s parent, he/she doesn’t have to live with taxpayer.
Note: A divorced parent who meets above rules and has signed IRS/legal document, may still claim HOH even if
dependency exemption shifted to ex-spouse
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*See pages 1-10 and 1-11 for requirement for abandoned spouse
Filing StatusFiling Status
Qualifying Widow(er) with Dependent Child◦Also known as surviving spouse◦Available for two subsequent years after
death of spouse Must pay over half the cost of maintaining a
household where a dependent child, stepchild, adopted child or foster child lives
◦Gets benefits of married filing joint tax rates
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Tax ComputationTax Computation
Six brackets (in Appendix)◦ 10%, 15%, 25%, 28%, 33%, 35%◦ Tax rate schedules for different filing types
Qualifying dividends and net long-term capital gains may be taxed at lower rates◦ Rates based on ordinary tax bracket
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Tax year 2010 laws are covered in this text. After 2010 many of the tax laws and rate structures passed 2001-2009 will “sunset”. The new tax rate structure will depend upon what Congress enacts.
Making Work Pay CreditMaking Work Pay Credit
This is a refundable credit amounting to $400 ($800 MFJ)
o Phases-out when AGI exceeds $75,000 ($150,000 MFJ)
o Complete Schedule M to calculate credito Available to both employees and self-employed
taxpayers
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Personal/Dependency Personal/Dependency ExemptionsExemptions
Personal exemptions may be taken for self and spouse
Additional exemptions may be taken for individuals who are either taxpayer’s◦ Qualifying child
or◦ Qualifying relative
For 2010 each exemption = $3,650
In years prior to 2010, exemptions phased-out for high-
income taxpayers. It is anticipated that the phase-out
will be reintroduced in 2011
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Dependency – Qualifying Dependency – Qualifying ChildChild
Dependency exemption allowed when six tests metRelationship Test - child is taxpayer’s child, stepchild,
adopted child or taxpayer’s sibling, half- or step-sibling, or a descendant of any of these. Foster child may also qualify. Child must be younger than person claiming him/her, unless permanently disabled.
Domicile Test- child has same principal place of abode as taxpayer for more than ½ the year.
Age Test – child is under 19 or a full-time student under 24 (enrolled at least 5 months of year).
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Dependency – Qualifying Dependency – Qualifying ChildChild Joint Return Test – child doesn’t file joint return with
spouse (exception: if it’s only to claim refund, then considered to have passed this test).
Citizenship Test – child is a US citizen, a resident of the US, Canada or Mexico, or an alien child adopted by and living with a US citizen.
Self-Support Test – child who provides more than ½ of his/her own support cannot be claimed as a dependent of someone else. Funds received by students as scholarships are excluded from support test.
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What if Child MeetsWhat if Child Meets Dependency Requirements for Dependency Requirements for
More than One Taxpayer?More than One Taxpayer?If one of the parties is a parent,
he/she can claimIf both parties are a parent, then
one with whom the child resides longest can claimo If not ascertainable, parent with
highest AGI may claim If no parents are involved, person
with highest AGI may claim2011 Cengage Learning 30
Dependency – Qualifying Dependency – Qualifying RelativeRelative
Dependency exemption may be granted for a qualifying relative (who is not a qualifying child) based on tests on next slide.
Note: A taxpayer’s child who does not meet qualifying child test may meet qualifying relative test!!
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Dependency – Qualifying Dependency – Qualifying RelativeRelative
Relationship or Member of Household Test – list of relatives that qualify is available at IRS web site
Note: A member of household (even if unrelated) for entire year meets the relationship test
Gross Income Test – individual may not have gross income in excess of $3,650
Support Test – dependent must receive over ½ of his/her support from taxpayer
Joint Return Test – dependent may not file a joint return unless it’s solely to claim refund
Citizenship Test – dependent must meet the citizenship test identified in the qualifying child slide
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Standard DeductionStandard Deduction
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2010 standard deductionSingle $ 5,700
Married Filing Joint (MFJ) $11,400Qualifying Widow(er) $11,400 also known as Surviving Spouse
Head of Household (HOH) $ 8,400
Married Filing Separate (MFS) $ 5,700
*Plus additional amounts for blindness or over 65: $1,100 if MFJ, MFS or qualifying widow(er) and $1,400 if HOH or Single
For 2008-2009 (and likely extended to 2010), taxpayer may add lesser of $500 (or $1,000 MFJ) or actual real estate
taxes paid to standard deduction amount.
Standard Deduction - Standard Deduction - DependentsDependents
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The special rule for standard deduction for dependents is “Deduction = Greater of $950 or earned income + $300, but only up to basic standard deduction”
Example 1: Jaime is 23 and a full time student and her parentsclaim her as a dependent; she earned $2,000 in 2010, how much is taxable income?
$2,000 earned income(2,000) standard deduction $0 taxable income
Example 2: Tia is 18 - has dividend income of $1,500 (dividends are considered unearned income), how much is taxable income?
$1,500 dividend income( 950) standard deduction$ 550 taxable income
Basic Gain & Loss ModelBasic Gain & Loss Model
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Amount Realized*
- Adjusted Basis**
Realized Gain/Loss* Sales Price - Sales Expenses
** Cost - Accumulated Depreciation
Note: Most realized gains/losses are also
recognized (i.e. – included in taxpayer’s income)
Capital Gains/LossesCapital Gains/Losses
A capital asset is any property (personal or investment) held by a taxpayer, with certain exceptions as listed in the tax law ◦ Examples: stocks, bonds, land, cars and other
items held for investment◦ Gains/losses on these assets are subject to
special rates Holding period of asset determines
treatment ◦ Long-term is held >12 months (taxed at capital
rates – see next screen)◦ Short-term is held <= 12 months (taxed at ordinary
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Capital Gains/LossesCapital Gains/Losses
Long term capital gain
◦ Special rates depending upon taxpayer’s bracket
Ordinary Tax Bracket Capital Gains Tax Rate
10% or 15% 0%
All other brackets 15%
Long term capital loss
◦ Only allowed $3,000 net capital loss per year against ordinary income
◦ Carry-forward any unused balance
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Calculating Gain/LossCalculating Gain/Loss
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Facts: Noah purchased Sony AAA bonds in 2006 for $47,600. In 2010, he sold the bonds for $51,500, paying commission of $515. What is his:
Amount realized ___________
Adjusted basis ___________
Realized gain/loss ___________
Recognized gain/loss ___________
Type of gain/loss ___________
SolutionSolution
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Amount realized * $50,985
Adjusted basis 47,600
Realized gain/loss 3,385
Recognized gain/loss 3,385
Type of gain/loss Long term capital gain
*Amount realized = $51,500 – 515
Tax and The InternetTax and The Internet
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Volumes of tax information available on interneto http://www.irs.gov contains forms and
publications and a search engine to aid the user in obtaining useful information
The IRS has also launched a YouTube video site and an iTunes podcast site
In some states, names of delinquent taxpayers posted on web sites
The End!The End!
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