Chapter 1


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Chapter 1

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