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11 - Income Taxation of Individuals Chapter 11
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Income Taxationof
Individuals
Chapter 11
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Individual Income Tax Model
Gross incomeLess: Deductions for adjusted gross incomeEquals: Adjusted Gross Income (AGI)Less: Itemized or standard deductionLess: Personal & dependency exemptionsEquals: Taxable income
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Tax Model (continued)
Taxable incomeTimes: Tax rateEquals: Gross income tax liabilityLess: Tax credits Plus: Additions to taxLess: Tax prepaymentsEquals: Net tax due or tax refund
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Deductions For AGI
Deductions discussed in previous chaptersRetirement plan contributions including IRAsMoving expenses 50% of self-employment taxesSelf-employed health insurance Alimony paid
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Deductions For AGI
Deductions discussed in this chapterEducator expensesStudent loan interest expenseTuition and fees deductionHealth savings accountsPenalty on early withdrawals of savingsOther deductions for AGI
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Educator Expenses
Kindergarten through 12th grade teachers may deduct up to $250 of unreimbursed expenses for books, supplies, computer equipment, software, and other supplemental materials used in the classroom
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Student Loan Interest
Deduction allowed for interest paid on qualified student loans incurred and used for tuition, fees, room, board, books, and supplies
Deduction limit is $2,500Limit is phased out for modified AGI of $60,000
- $75,000 ($120,000 - $150,000 for married persons filing jointly)
Individuals claimed as dependents cannot take deduction on their own tax return
Eligible expenses must be reduced for tax-exempt scholarships and education credits
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Tuition & Fees Deduction
$4,000 deduction for tuition & fees for taxpayer, spouse, and dependentsIncome limits apply ($65,000 if single and $130,000
if married filing jointly)Deduction is reduced to $2,000 for singles with
income $65,000 - $80,000 ($130,000 - $160,000 for joint filers)
Individuals who are claimed as dependents cannot take deduction on their own tax return
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Health Savings Accounts
Taxpayers covered by high-deductible medical insurance policies only may deduct amounts set aside in an HSA
Contributions and earnings on HSAs are not taxed when withdrawn to pay medical expensesDistributions not spent on qualifying expenses
are included in income and subject to a 10% penalty
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Health Savings Accounts
To qualify for an HSA in 2009, individuals must have health insurance with deductibles of at least $1,150 ($2,300 for families)
Maximum deductible contribution to HSA for 2009 is $3,000 ($5,950 for families)
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Medical Savings Accounts
MSAs are similar to HSAs but with different limitsQualified policies are those with deductibles of
$2,000 - $3,000 for individuals ($4,000 - $6,050 for families) in 2009
Contributions to MSAs are limited to 65% of policy deductible for individuals (75% for families)
Distributions not spent on qualifying expenses are included in income and subject to a 15% penalty
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Penalty on Early Withdrawals
Penalties assessed on premature withdrawals from certificates of deposits or other savings accounts are deductibleGross interest income, unreduced by the
penalty, is included in taxable incomeDeducting the penalty ensures that only net
interest income is included in taxable income
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Other Deductions For AGI
Unreimbursed travel expenses to attend National Guard or military reserve meetings more than 100 miles from home Maximum deduction is general
government per diem rate for the area Expenses of fee-basis government
officials Expenses of performing artists
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Exemptions
Each taxpayer (who is not a dependent) is entitled to one personal exemption
Exemption deduction is $3,650 for 2009 Additional exemptions allowed for each person who
is considered a dependentAnyone who is claimed as a dependent cannot claim
a personal exemptionFor purposes of the dependency exemption, a
dependent is a qualifying child or qualifying relative
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Qualifying Child
Must meet four tests1. Residency test - live with taxpayer more than 6
months2. Relationship test - son, daughter, brother, sister,
or descendant3. Age test - under 19 (or under 24 if full-time
student)4. Support test - child cannot provide more than half
his own support
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Qualifying Relative
If not a qualifying child, then three similar tests must be met:
1. Relationship test - must either be a qualifying relative of the taxpayer or a resident in the taxpayer’s household for the entire year
2. Gross income test - the qualifying relative's gross income from taxable sources must be less than the exemption amount ($3,650 for 2009)
3. Support test
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The Support Test
Taxpayer must provide more than 50% of the dependent's total supportSupport includes amounts spent for food,
clothing, shelter, medical care, education and capital expenditures such as a car
Value of services and scholarship funds are omitted in determining support received by a student
Dependent’s nontaxable income used for support must be included
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Multiple Support Agreement
Multiple support agreements allow one member of group of support providers to claim the exemption whenTogether the group meets the support testAll other dependency tests are metMember who claims exemption must provide
more than 10% of the total support and other members providing more than 10% support agree to exemption
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Phaseout of Exemptions
One-third of both personal and dependency exemptions are phased out at a rate of 2% for each $2,500 ($1,250 if MFS), or fraction thereof, of AGI (up to a maximum of 100%) above thresholds for 2009 of$166,800 if single$208,500 if head of household$250,200 if married filing jointly$125,100 if married filing separately
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Exemption Phaseout
1) (AGI – threshold AGI)/$2,500 = Phaseout Factor (always round up to next whole number)
2) Phaseout Factor x 2 = Phaseout Percentage3) Phaseout Percentage x Exemption Amount x
1/3 = Exemption Reduction4) Exemption Amount – Exemption Reduction =
Allowable Exemption Deduction Once AGI exceeds the threshold AGI by more
than $122,500 ($61,250 for MFS), the maximum deduction is $2,433 per exemption
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Filing Status
Taxpayer’s filing status determines standard deduction and tax rate schedule
Marital status determined on the last day of the tax yearSeparated spouses are considered
married until divorce becomes final
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Filing Status - Married
Can file jointly if both spouses are US citizens or US residents (or if nonresident alien agrees to be taxed on worldwide income)
If the couple files separately, both must itemize deductions or both must use the standard deduction
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Surviving Spouse
Marital status is determined at the date of death so a joint return can be filed for the year in which a spouse dies
A surviving spouse may continue to use the tax rates and standard deduction for married persons filing jointly for the next 2 years only if a dependent child lives with the taxpayer
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Filing Status – Unmarried
Unmarried taxpayers file asHead of household – an unmarried person
who provides more than half of the cost of maintaining a home in which a qualifying child or other qualifying relative lives for more than half the year
Single – taxpayer who does not qualify for another filing status
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Head of Household
Claimed if taxpayer is unmarried (and not a surviving spouse)
Taxpayer pays more than half the cost of maintaining home which is the principal residence for more than half the year of
1) A qualifying child2) An individual for whom the taxpayer may claim a
dependency exemption A parent is not required to live with the taxpayer
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Abandoned Spouse
A taxpayer who is married but whose spouse did not live with him or her at any time during the last six months of the tax year and who provides more than half the cost of maintaining the home in which a dependent child lives
A qualifying abandoned spouse uses head of household tax rates and standard deduction
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Standard Deductions
Standard Deductions for 2009 $11,400 married filing a joint return $5,700 married filing separately $8,350 head of household $5,700 single individual
Additional standard deduction if taxpayer is elderly (age 65 or older) or blind $1,400 if single or head of household $1,100 if married
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Temporary Additions toStandard Deduction
To promote the sales of automobiles, taxpayers can increase their standard deduction for sales tax paid on the purchase of an automobile Vehicle must be purchased after 2/16/09 and
before 1/1/2010 Deduction limited to tax on no more than $49,500 Deduction is phased out for modified AGI
between $125,000 and $135,000 ($250,000 and $260,000 if MFJ)
Taxpayers who itemize can claim the sales tax on an automobile as part of their overall sales tax deduction
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Temporary Additions toStandard Deduction
Taxpayers will be allowed an additional standard deduction in 2008 and 2009 equal to the lesser of State and local real property taxes paid or $500 ($1,000 if married filing a joint return)
Taxpayers with personal casualty losses incurred in federally declared disaster areas than occur before 1/1/2010 Can increase their standard deduction for their
casualty loss or Claim the casualty losses with itemized
deductions
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Dependent’s Standard Deduction
Dependent’s standard deduction is limited to the greater of:
1) $950 or2) Earned income + $300 (up to otherwise
allowable standard deduction) Earned income includes salary and wages Earned income does not include interest
income, dividend income, capital gains, or income as beneficiary of a trust
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Itemized Deductions
Itemized deductions provide tax benefit only to the extent that, in total, they exceed the taxpayer’s standard deduction
Taxpayers can maximize use of the standard deduction and itemized deductions by timing certain deductible payments
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Medical Expenses
Medical expenses paid for the taxpayer, spouse and dependents, after reduction for insurance reimbursements, are deductible only to the extent they exceed 7.5% of AGI for the year
Qualified medical costs includes prescription drugs and insulin, costs of a hospital, clinic, doctor, dentist, eyeglasses, contract lenses, transportation for medical care and health insurance costs
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Medical Expenses
Health insurance premiums for taxpayers and their dependents are deductible only if paid from after-tax incomePremiums paid through an employer-
sponsored cafeteria plan are not deductiblePremiums for disability insurance and for
loss of life, limb or income are not deductiblePremiums for long-term care insurance are
deductible, subject to limits based on age
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Deductible Taxes
Deductible taxes includeState, local, and foreign real property taxesState and local personal property taxesState, local, and foreign income taxesOther federal, state, local, and foreign taxes
incurred in a business or other income-producing activity
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Deductible Taxes
Taxpayers can elect to deduct state and local general sales taxes instead of state and local income taxes as itemized deductionsTaxpayers who pay sales tax on the purchase
of an automobile will only get a tax benefit from the sales tax deduction if they do not claim a deduction for state or local income taxes
Taxpayers can use the actual sales tax paid or IRS-published tables (if tables used the actual sales tax paid on an auto can be added to the table amount)
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Nondeductible Taxes
Nondeductible taxes includeFederal income taxesEmployee's share of payroll taxes Federal excise taxes not incurred for
businessAssessments on property that increase
property value
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Interest Expense
Deductible interest includesInvestment interestHome mortgage interest
No deduction for most other personal interest (except previously mentioned student loan interest) including interest onAuto loansLife insurance loansCredit card debtDelinquent tax payments
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Investment Interest Expense
Investment interest includes interest on loans to acquire or hold investment property and margin account interest paid to a broker
Investment interest expense is only deductible to the extent of net investment incomeNet investment income = excess of investment
income over investment expenses Excess is carried forward (indefinitely) subject
to same limit in future years
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Investment Interest Expense
Investment income includes gross income from interest, annuities, and short-term capital gains from investment propertyLong-term capital gains or dividends taxed at
favorable rates are excluded unless election made to forgo the favorable rate
Investment expenses include safe deposit box rental fees, investment counsel fees, brokerage account maintenance feesLimited to the lesser of total investment
expenses or net miscellaneous itemized deductions after reduction for 2% AGI floor
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Qualified Residence Interest
Interest paid for acquisition debt or home equity debt for up to 2 qualified residences
Interest on acquisition debt of up to $1 million principal amount (combined limit for 2 homes) is deductibleAcquisition debt includes mortgage to buy,
construct, or improve the residence
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Qualified Residence Interest
Interest on up to $100,000 principal amount of home equity loan is deductibleLoan proceeds can be used for any purpose
Points (loan origination fees) paid on initial home mortgages are deductiblePoints paid to refinance an exiting loan must be
amortized over life of loan For 2007 – 2010, an additional deduction is
allowed for mortgage insurance premiums paid on home acquisition debt
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Charitable Contributions
Congress allows individuals, corporations, estates and trusts to deduct contributions to certain qualified organizations
Partnerships and S corporations pass the contributions through to their partners and shareholders who then claim the deductions on their own income tax returns
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Charitable Contributions
Qualified charitable organizationsGovernmental units (federal, state and local
governments) and entities formed and operated exclusively for religious, charitable, scientific, literary or educational purposes, including churches, nonprofit hospitals, school and universities, libraries, and social service agencies
Direct contributions to needy individuals are not deductible
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Charitable Contributions
No deduction allowed to the extent that valuable goods or services are received in return for the contributionException - contributors to universities who
receive preferred rights to purchase tickets for university athletic events may deduct 80% of the amount of their contribution
Individual’s deduction limited to 50% of AGIExcess contributions may be carried forward up
to 5 years
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Charitable Contributions
No deduction for contributions of the taxpayer’s services and rent-free use of the taxpayer’s propertyOut-of-pocket costs incurred for volunteer
work for a qualifying charity are deductible Property other than long-term capital gain
property is valued at lesser of FMV or basis
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Contributions of LTCG Property
LTCG property is valued at FMV (which is usually greater than adjusted basis) Tangible personalty given to a charity which does
not use the property in its tax-exempt activity is valued at adjusted basis, if lower than FMV
Deduction for LTCG property limited to 30% of AGI30% limit can be avoided (and 50% AGI limit
applied) if taxpayer elects to use lower basisIf made, election applies to all LTCG contributions
that year
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Charitable Contributions
Stocks or other income producing property that have declined in value should be sold so that the loss can be claimed with the sale proceeds donated
Fees incurred for appraisals of donated property may be deducted as a miscellaneous itemized deductions
Deduction for donated vehicles sold by charity limited to gross sales proceeds
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Charitable Contributions
Since 2007, all cash contributions must be substantiated by abank record (such as a canceled check, bank copy of a
canceled check, credit card statement or bank statement containing the name of the charity, the date, and the amount), or
written communication from the charity including the charity’s name, contribution date, and amount
Payroll deduction records (pay stub or W-2 form) plus pledge card or other document showing name of organization, date, and amount
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Charitable Contributions
Contributions of $250 or more requireA written acknowledgment showing date & amount of
contribution along with an estimate of the value of any goods or services you received
Noncash contributions of up to $500 requireA written acknowledgment showing name of charity,
your name, date and location of the contribution, and a detailed description of the property
Documentation of your cost for the property and an explanation of how you determined its fair market value
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Charitable Contributions
Noncash contributions over $500 require an acknowledgement and written records plusHow you acquired the property (purchase, gift,
inheritance or exchangeDate you acquired the propertyCost basis of property
For noncash contributions over $5,000, you must obtain a qualified appraisal
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Casualty and Theft Losses
Loss is the lesser ofAsset’s adjusted basis orDecline in asset’s fair market value as a result of
the casualty Loss is reduced for any insurance proceeds
received $500 floor for 2009 ($100 floor for all other
years) applies to each casualty Deductible only to extent total losses exceed
10% of AGI10% threshold does not apply to presidentially
declared disasters in 2008 or 2009
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Miscellaneous Deductions
Only excess over 2% of AGI is deductibleUnreimbursed employee business expensesJob hunting expenses (in searching for a new job
in current line of business)Investment-related expensesHobby expenses (up to hobby income)Tax preparation and planning advice
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Phaseout ofItemized Deductions
Total deductions phased out by 1/3 x 3% of AGI in excess of $166,800 in 2009 ($83,400 if MFS)
Exception - deductions not phased out forMedical expensesInvestment interestCasualty and theft losses
Total deductions are not reduced by more than 80% x 1/3 regardless of type
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Net Operating Losses
Individuals must make several adjustments to arrive at a potential NOL because an NOL can only result from business lossesNo deduction for personal or dependency
exemptionsNonbusiness capital losses can only offset
nonbusiness capital gainsNonbusiness deductions (most itemized
deductions) can only offset nonbusiness income (such as interest & dividends)
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Tax Rates forMarried Filing a Joint Return
For married filing a joint return for 2009• 10% on first $16,700 taxable income• 15% on $16,701 - $67,900• 25% on $67,901 - $137,050• 28% on $137,051 - $208,850• 33% on $208,851 - $372,950• 35% over $372,950
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Tax Rates forMarried Filing Separately
For married filing separately for 2009• 10% on first $8,350 taxable income• 15% on $8,351 - $33,950• 25% on $33,951 - $68,525• 28% on $68,526 - $104,425• 33% on $104,426 - $186,475• 35% over $186,475
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Tax Rates forHead of Household
For head of household for 2009• 10% on first $11,950 taxable income• 15% on $11,951 - $45,500• 25% on $45,501 - $117,450• 28% on $117,451 - $190,200• 33% on $190,201 - $372,950• 35% over $372,950
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Tax Rates for Single Individuals
For single individuals for 2009• 10% on first $8,350 taxable income• 15% on $8,351 - $33,950• 25% on $33,951 - $82,250• 28% on $82,251 - $171,550• 33% on $171,551 - $372,950• 35% over $372,950
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Special Tax Rates
Dividend income is taxed at a maximum of 15% (zero rate for taxpayers in 10% or 15% tax brackets)
Individuals with long-term capital gains file a Schedule D which includes a worksheet for determining the total tax liabilityLTCG rate generally 15% (zero rate for taxpayers
in 10% or 15% tax brackets)28% rate for collectibles25% rate for unrecaptured §1250 gain & taxable
portion of §1202 small business stock
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Credits vs. Deductions
Deductions only reduce tax liability by a percentage based on the taxpayer’s marginal tax rate
Credits are direct dollar-for-dollar reductions in the gross tax liability Tax credits have the same dollar value
to all taxpayers, regardless of their marginal tax brackets
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Child Tax Credit
$1,000 nonrefundable tax credit for each qualifying child under age 17Qualifying children include the taxpayer’s son,
daughter, stepson, stepdaughter, grandchild, or eligible foster child that the taxpayer claims as a dependent
Phased out at rate of $50 for every $1,000 (or part thereof) of AGI in excess of$110,000 if married filing jointly ($55,000 if MFS)$75,000 if single or head of household
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Education Credits
Two elective nonrefundable tax credits are provided for college or vocational tuition and fees for the taxpayer, spouse, or dependents American Opportunity Credit – 100% of first $2,000
and 25% of second $2,000 tuition and fees for first 4 years only (maximum $2,500 per student)
Lifetime Learning Credit – 20% of up to $10,000 tuition and fees (maximum $2,000 per taxpayer)
A student who is a dependent cannot claim the credit
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Education Credits
Expenses paid with a Pell Grant, scholarship, or employer-provided educational assistance do not qualify
Election is separate for each student, so a parent may choose one credit for one child and a different credit for a second child
Credits phase out over modified AGI of$80,000 - $90,000 if single ($160,000 - $180,000 if
MFJ) for American Opportunity credit$50,000 - $60,000 if single ($100,000 - $120,000 if
MFJ) for Lifetime Learning credit
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Dependent Care Credit
Nonrefundable credit for taxpayers who pay for child or dependent care so they can work
Credit percentage varies from 20% to 35% of up to $3,000 for one qualifying child or $6,000 for 2 or more qualifying children under 1335% if AGI does not exceed $15,000Reduced by 1% for each $2,000 (or fraction
thereof) AGI exceeds $15,00020% if AGI exceeds $43,000
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First-Time Homebuyer Credit
Credit applies to purchase of principal residence if no home owned (by taxpayer or spouse) during 3 prior years. This refundable tax credit is equal to the lesser of10% of the purchase price of a principal residence$8,000 maximum ($4,000 for married filing
separately) if purchased from 1/1/09 through 11/30/09$7,500 maximum ($3,750 if MFS) if purchased from
4/9/08 through 12/31/08 Cannot be acquired from a related party
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First-Time Homebuyer Credit
Credit phases out when modified AGI is between $75,000 and $95,000 ($150,000 - $170,000 for married filing jointly)
Credit is recaptured (must be repaid) If home purchased in 2009 ceases to be taxpayer’s
principal residence within 36 months then lesser of gain on sale or entire credit is recaptured
If purchased in 2008, credit must be recaptured over 15 years (effectively an interest-free loan)
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New Homebuyer Credit
The credit is recaptured over 15 years, beginning with the second tax year after the home is purchasedFor each year, the credit is recaptured as an
additional income tax amount equal to 6.67% of the amount of the credit
If the home is sold, any remaining unrecaptured credit is paid with the tax return for the year of sale
No interest is charged (in effect this is an interest-free loan from the government)
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Earned Income Credit
The purpose is to reduce the impact of payroll taxes for low-income individuals
Credit is equal to a percentage of earned income below a maximumWith one qualifying child, maximum credit is
$3,043 ($8,950 x 34%) for 2009With two or more qualifying children, maximum
credit is $5,028 ($12,570 x 40%)Smaller credit available to taxpayers without
children
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Earned Income Credit
This is a refundable credit Taxpayers with investment income of $3,100 or
more are not eligible Anyone who can be claimed as a dependent is
not eligible A taxpayer without a qualifying child, must be
between the ages of 25 and 64 to be eligible Credit starts phasing out when income exceeds
$19,540 if married filing jointly ($16,420 for others)
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Making Work Pay Credit
New refundable credit for 2009 and 2010 for Social Security taxes paid by middle-income workers of 6.2% of earned incomeMaximum credit $400 ($800 for a joint return)
Phased out at rate of 2% of modified AGI in excess of$75,000 for individuals$150,000 for married filing jointly
Most taxpayer will get benefit through reduction in income tax withholding
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Retirement Contributions Credit
To encourage participation by low-income wage earners, a credit is allowed for up to 50% of the first $2,000 contributed to employer-sponsored retirement plans or IRAs
Credit varies with AGI50% credit for joint filers with AGI up to $33,000
($16,500 if single)20% for joint filers with AGI of $33,000 - $36,000
($16,500 - $18,000 if single)10% for joint filers with AGI of $36,000 - $55,500
($18,000 - $27,750 if single)Dependents or full-time students are not eligible
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Excess Payroll Tax Credit
Taxpayers working for more than one employer during the year with earnings exceeding the Social Security ceiling ($106,800 for 2009) usually have too much tax withheld
Employee is allowed a refundable credit for any excess Social Security taxes withheld
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Credits for Energy Efficiency
30% for qualified energy efficiency improvements ($1,500 maximum credit per taxpayer)
30% for solar, wind, and geothermal property Credit for hybrid vehicles (varies with type of
vehicle)$2,200 credit for Cadillac Escalade 2WD hybrid$2,300 credit for Mazda Tribute 2WD hybrid$7,500 to $15,000 credit for plug-in electric cars
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Payment of Income Tax
Estimated quarterly payments are made by persons with large amounts of income from sources not subject to withholdingDue on April 15, June 15, September 15 of
current year and January 15 of following year If payments are not 90% or more of the total
tax owed (or an amount required based on the prior year’s tax), a penalty may be charged, unless balance due is less than $1,000
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Economic Stimulus Rebates
For 2008 a one-time rebate (tax credit) was paid of $300 to $600 per individual plus an additional $300 for each qualifying dependent childMost individuals received an advanced payment
of their rebate in May 2008 Individuals were not eligible for tax rebates if
they wereEligible to be claimed as dependents or Nonresident aliens
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Filing Requirements
Any taxpayer whose gross income is less than the sum of their standard deduction and their personal exemption (but not dependency exemptions) does not have to file a tax return
$9,350 in 2009 for a single individual Returns should be filed if
1) Net self-employment income is $400 or more2) A child claimed as a dependent has unearned
income only of over $950 3) Any married person filing separately has
income over $3,650
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Alternative Minimum Tax
The purpose of the alternative minimum tax is to ensure high-income taxpayers pay their fair share of tax
Certain deductions are disallowed or reduced and certain exempt income items are subject to the AMT
IF AMT is greater than the regular tax, taxpayers pay the larger amount
Rate is 26% on first $175,000 and 28% on excess for individuals
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AMT Model
Taxable incomePlus/minus Adjustments to taxable incomePlus: Tax preferencesLess: Allowable exemptionsEquals: Alternative minimum taxable incomeTimes: AMT tax rates Equals: Tentative minimum tax (TMT)Less: Regular income taxEquals: AMT
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AMT Exemptions
AMT exemptions for 2009 are$70,950 if married filing jointly$35,475 if married filing separately$46,700 if single or head of household
Exemptions begin to phase out when AMTI reaches $112,500 for singles and $150,000 for married filing jointly ($75,000 if MFS) at a rate of $1 for every $4 above the threshold
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Alternative Minimum Tax
Itemized deductions are different from those calculated for regular income tax Medical expenses must exceed 10% AGITaxes, home equity loan interest, and
miscellaneous itemized deductions are not deductible
Tax preferences that are added includeNontaxable interest on private activity bondsBargain element of incentive stock options
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The End
