This document summarizes key aspects of individual income tax calculations in the United States, including: 1) It outlines the basic formula for calculating individual tax liability, including components like gross income, deductions, exemptions, taxable income, tax rates, credits, and payments. 2) It describes the requirements for determining personal and dependency exemptions, including the definitions of a qualifying child and qualifying relative. 3) It explains the different filing statuses individuals can use, including married filing jointly, head of household, and qualifying widow. Examples are provided to illustrate how to determine the proper filing status.

1. © 2014 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any manner. This
document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
Chapter 4
Individual Tax Overview

2. 4-2
Learning Objectives
1. Describe the formula for calculating an
individual’s tax liability and generally
explain each formula component.
2. Explain the requirements for determining a
taxpayer’s personal and dependency
exemptions.
3. Determine a taxpayer’s filing status.

3. 4-3
Individual Income Tax Formula
 Gross income
 Minus: For AGI deductions
 Equals Adjusted gross income
 Minus: From AGI deductions:
 Greater of (a) Standard deduction or
(b) Itemized deductions and
 Personal and dependency exemption
 Equals Taxable income

4. 4-4
Individual Income Tax Formula
 Taxable income
 Times: Tax rates
 Equals: Income tax liability
 Add: Other taxes
 Equals: Total tax
 Minus: Credits
 Minus: Prepayments
 Equals: Taxes due or (refund)

5. 4-5
Individual Income Tax Formula
 Individuals report taxable income to the IRS
 Reported on Form 1040
 U.S. tax laws use all-inclusive gross income
concept
 Realized income
 measurable change in property rights
 All realized income included in gross income unless
specifically excluded or deferred
 Recognized income
 Reported on tax return

6. 4-6
Individual Income Tax Formula
 Excluded and Deferred income not included
in gross income
 Excluded income
 Income never included in taxable income
 Municipal bond interest
 Gain on sale of personal residence
 Deferred income
 Income included in a subsequent tax year
 Installment sales
 Like-kind exchanges

7. 4-7
Individual Income Tax Formula
 Character of income or loss
 Determines rates applicable to income or loss in current
year
 Tax exempt – no tax
 Tax deferred – no tax in current year (current year tax rate
is zero)
 Ordinary – ordinary rates from tax rate schedule
 Qualified dividends – 0 or 15%
 Capital gain or loss – depends on whether short-term or
long-term
 From selling capital asset
 If held capital asset more than a year gain or loss is long-
term, otherwise it is short-term

8. 4-8
Individual Income Tax Formula
 Capital assets
 Generally all assets except
 Accounts receivable
 Inventory
 Assets used in trade or business, including supplies

9. 4-9
Individual Income Tax Formula
 Capital gains and losses
 Long-term capital gains generally taxed at 0%,
15%, or 20% depending on the taxpayer’s taxable
income
 Short-term capital gains taxed at ordinary rates
 Net capital losses (losses in excess of gains for
year)
 $3,000 deductible against ordinary income for year
 Losses in excess of $3,000 carried forward

10. 4-10
Individual Income Tax Formula
 Deductions for AGI
 Deductions “above the line”
 Deducted in determining adjusted gross income
 Always reduce taxable income dollar for dollar

11. 4-11
Individual Income Tax Formula
 Deductions from AGI
 Deductions “below the line”
 Deducted from adjusted gross income to
determine taxable income
 Greater of standard deduction or itemized
deductions
 Personal and dependency exemptions
 Why might a from AGI deduction not reduce
taxable income?

12. 4-12
Individual Income Tax Formula
 2013 Standard deduction amounts
 $12,200 Married filing jointly
 $12,200 Qualifying widow or widower
 $6,100 Married filing separately
 $8,950 Head of household
 $6,100 Single
 Additional standard deduction amounts for age
and eyesight (discuss in Chapter 6)

13. 4-13
Individual Income Tax Formula
 Tax calculation
 The U.S. uses a progressive tax rate schedule
 Some items are taxed at preferential rates
 Long-term capital gains
 Qualified dividends
 Tax on these items is calculated separately from
income taxed at ordinary rates.

14. 4-14
Individual Income Tax Formula
 Other taxes include:
 Alternative minimum tax
 Self-employment taxes
 Medicare Contribution tax on net-investment
income
 Tax credits
 Reduce tax liability dollar for dollar

15. 4-15
Individual Income Tax Formula
 Tax prepayments
 Payments already made towards tax liability including:
 Income taxes withheld from wages by employer
 Estimated tax payments made during the year
 Taxes overpaid in prior year and applied toward current
year’s liability
• If prepayments exceed tax liability after
credits, taxpayer receives a refund

16. 4-16
Personal and Dependency Exemptions
 Personal exemptions
 For taxpayer and spouse if married filing jointly
 Dependency exemptions
 For those who qualify as the taxpayers’
dependents
 Exemption amount for 2013 is $3,900

17. 4-17
Personal and Dependency Exemptions
 Dependency requirements
 Citizen of U.S. or resident of U.S., Canada, or
Mexico
 Must not file joint return with spouse
 Exception – if no tax liability filing jointly or separately
 Must be qualifying child or qualifying relative of
taxpayer

18. 4-18
Personal and Dependency Exemptions
 Qualifying child
 Relationship test
 Age test
 Residence test
 Support test

19. 4-19
Qualifying Child
 Relationship test
 taxpayer’s son, daughter, stepchild, an eligible
foster child, brother, sister, half brother, half sister,
stepbrother, stepsister or a descendant of any of
these relatives.

20. 4-20
Qualifying Child
 Age test: child must be younger than the
individual claiming the child as a qualifying
child and either
 under age 19 at the end of the year,
 under age 24 at the end of the year and a full-
time student, or
 permanently and totally disabled.

21. 4-21
Qualifying Child
 Residence test
 Same residence as taxpayer for more than half
the year
 Exception for temporary absences such as education.
 Support test
 Child must not provide more than half of his or her
own support
 Scholarships of actual child (not grandchild, for
example) are excluded from support computation

22. 4-22
Qualifying Child Example
Rodney and Anita have two children: Braxton,
age 12, who lives at home and Tara, age 21
who is a full-time student and does not live at
home. While Tara earned $9,000 in a summer
job, she did not provide more than half of her
own support during the year. Are Braxton and
Tara qualifying children to Rodney and Anita?

23. 4-23
Qualifying Child Example Solution
Test Braxton Tara
Relationship Yes, son Yes, daughter
Age Yes, < 19 at year-end
(and younger than his
parents)
Yes, < 24 at year-end
and full-time student
(and younger than his
parents)
Residence Yes, lived at home
entire year
Yes, temporary
absences such as
school ok
Support Yes, he provides < ½ Yes, parents provide >
½ (scholarship does
not count as self
-support)

24. 4-24
Qualifying Child
 Tie breaking rules
 Parents first
 Days living with each parent if parents living apart
 AGI– higher AGI gets exemption

25. 4-25
Qualifying Child Example
Braxton’s uncle Shawn (Rodney’s brother) lived
in the Halls’s home (the same home Braxton
lived in) for more than 11 months during 2013.
Does Braxton meet the requirements to be
considered Shawn’s qualifying child?

26. 4-26
Qualifying Child Example Solution
Test Is Braxton Shawn’s qualifying child?
Relationship Yes, son of Shawn’s brother
Age Yes, < 19 at year-end (and younger than Shawn)
Residence Yes, lived in the same residence as Shawn for
more than half the year
Support Yes, does not provide more than half of own
support

27. 4-27
Qualifying Child Example
Braxton is considered to be Rodney and
Anita’s qualifying child and he is considered to
be Shawn’s qualifying child. Under the
tiebreaker rules, who is allowed to claim
Braxton as a dependent for the year?

28. 4-28
Qualifying Child Example Solution
Answer: Rodney and Anita. Under the first
tiebreaking rule, Rodney and Anita are allowed
to claim the dependency exemption for Braxton
because they are Braxton’s parents.

29. 4-29
Personal and Dependency Exemptions
 Qualifying relative
 Relationship test
 Support test
 Gross income test

30. 4-30
Qualifying Relative
 Relationship test
 a descendant or ancestor of the taxpayer (e.g.,
child, grandchild, parent, or grandparent),
 a sibling of the taxpayer including a stepbrother or
stepsister
 a son or daughter of the taxpayer’s brother or
sister (not cousins)
 a sibling of the taxpayer’s mother or father
 in-law (mother-in law, father-in-law, sister-in-law,
and brother-in-law) of the taxpayer, or
 unrelated person who lives in taxpayer’s home
entire year

31. 4-31
Qualifying Relative
 Support test
 Taxpayer must pay > ½ of living expenses
(support)
 Scholarships of actual child excluded
 Gross income test
 Gross income < personal exemption amount

32. 4-32
Dependency Exemption Example
 John is a 22-year old student who has lived in
the dorms for most of the year but spends the
rest of the year living with his parents. He
earned a $5,000 scholarship for the school year
and has worked hard to support himself through
school earning $6,000 to pay for his own
expenses. His parents have supported him by
paying for $7,000 for food, clothing, and lodging
expenses. Are John’s parents able to claim him
as a dependent?

33. 4-33
Dependency Exemption Example
Solution
Test Qualifying child Qualifying
relative
Relationship Yes, child Yes, child
Age Yes, < 24 and full-time
student
Not applicable
Residence Yes, temporary
absences ok
Not applicable
Support Yes, he provides < ½ Yes, parents
provide > ½
Gross income Not applicable No, gross
income > $3,900

34. 4-34
Personal and Dependency Exemptions

35. 4-35
Filing Status
 Five different filing statuses
 Married filing jointly
 Married filing separately
 Qualifying widow or widower (surviving spouse)
 Single
 Head of household

36. 4-36
Filing Status
 Married filing jointly
 Must be married on the last day of the year
 If one spouse dies the surviving spouse is considered
to be married to decedent spouse at year end
 Exception – The surviving spouse remarries before year end
 Joint and several liability for tax

37. 4-37
Filing Status
 Married filing separately
 Taxpayers are married but file separate returns
 Typically not beneficial from tax perspective
 Tax rates and other tax benefits
 May be beneficial for non-tax reasons
 No joint and several liability

38. 4-38
Filing Status
 Qualifying widow or widower
 Available for the two years following the year of
spouse’s death
 Surviving spouse does not qualify if remarries
during two-year period.
 Surviving spouse must maintain household for
dependent child

39. 4-39
Filing Status
 Single
 Unmarried unless qualify for head of household

40. 4-40
Filing Status
 Head of household
 Unmarried or considered unmarried at end of year
 See discussion of married individuals treated as
unmarried (abandoned spouses) below
 Not a qualifying widow or widower
 Pay more than half the costs of keeping up a
home during the year
 Lived in taxpayer’s home with a “qualifying
person” for more than half of the year
 Exception for parents (see below)

41. 4-41
Filing Status
 Qualifying person
 Qualifying child
 Qualifying relative who is taxpayer’s mother or
father
 Parent need not live with taxpayer
 Taxpayer must pay > ½ cost of maintaining separate
household for taxpayer’s mother or father
 Parent must qualify as taxpayer’s dependent

42. 4-42
Filing Status
 Qualifying relative who is not the taxpayer’s
parent
 Person must have lived with taxpayer for more than
half the year
 Must qualify as taxpayer’s dependent
 Must be related to taxpayer through qualified family
relationship
 If related only because lived with taxpayer for entire year,
not a qualified person.

43. 4-43
Filing Status
 Head of household
 Married individuals treated as unmarried
(abandoned spouse) if individual
 Is married at end of year (or is not legally separated from
the other spouse)
 Does not file a joint tax return with the other spouse
 Pays > ½ the cost of maintaining a household that
serves as principal abode for qualifying child for more
than half the year
 Lived apart from the other spouse for the last six months
of the year (other than temporary absences)

44. 4-44
Filing Status Example
Assume that last year Rodney passed away,
and during the current year Anita did not
remarry but maintained a household for
Braxton and Tara, her dependent children.
Under these circumstances, what would Anita’s
filing status be?

45. 4-45
Filing Status Example
Answer: Qualifying widow

46. 4-46
Filing Status Example
Assume Rodney and Anita divorced last year.
During the current year, Braxton lives with Anita
and Anita pays all the costs of maintaining the
household for herself and Braxton. Under these
circumstances, what is Anita’s filing status for
the current year?

47. 4-47
Filing Status Example
Answer: Head of household

48. 4-48
Filing Status Example
Assume Shawn (Rodney’s brother) lived with the
Halls, but Shawn paid more than half the costs of
maintaining a separate apartment that is the principal
residence of his mother, Sharon, whose gross income
is $1,500. Because Shawn provided more than half of
Sharon’s support during the year, and because
Sharon’s gross income was only $1,500, she qualifies
as Shawn’s dependent (as a qualifying relative). In
these circumstances, what is Shawn’s filing status?

49. 4-49
Filing Status Example
Answer: Head of household. Shawn paid
more than half the costs of maintaining a
separate household that is the principal place
of abode for his mother, and his mother
qualifies as his dependent.