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Chapter 1


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Chapter 1

  1. 1. Income Tax Fundamentals 2010 edition Gerald E. Whittenburg Martha Altus-Buller 2010 Cengage Learning
  2. 2. <ul><li>Since 1913 - adoption of 16 th amendment - the constitutionality of income tax has never been questioned </li></ul><ul><li>Income taxes serve a multitude of purposes </li></ul>2010 Cengage Learning
  3. 3. <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>2010 Cengage Learning
  4. 4. <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>2010 Cengage Learning See next slide
  5. 5. <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><ul><li>Only wages, salaries or unemployment and not more than $1,500 taxable interest income </li></ul></ul></ul></ul><ul><ul><ul><li>Not received advance earned income credit </li></ul></ul></ul>2010 Cengage Learning
  6. 6. <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>2010 Cengage Learning
  7. 7. <ul><li>Corporations </li></ul><ul><ul><li>Tax rate schedule found on page 1-3 </li></ul></ul><ul><ul><li>1120 </li></ul></ul><ul><ul><li>or </li></ul></ul><ul><ul><li>1120S - 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>2010 Cengage Learning
  8. 8. <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: Exemptions </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>2010 Cengage Learning
  9. 9. 2010 Cengage Learning <ul><li>2009 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) $ 8,350 </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>2009 exemption $3,650 – personal & dependency </li></ul>
  10. 10. 2010 Cengage Learning <ul><li>Facts: Juan (age 29) is a single taxpayer. In 2009, 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>Adjusted gross income ___________ </li></ul><ul><li>Greater of the standard </li></ul><ul><li>deduction or itemized deductions ___________ </li></ul><ul><li>Taxable income ___________ </li></ul>
  11. 11. 2010 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>Taxable income ___________ </li></ul><ul><li>Gross income = $39,000 + 1,000 </li></ul>
  12. 12. 2010 Cengage Learning Gross income $40,000 Adjusted gross income 37,500 Greater of the standard deduction or itemized deductions ___________ Taxable income ___________ AGI = $40,000 – 2,500
  13. 13. 2010 Cengage Learning Gross income $40,000 Adjusted gross income 37,500 Greater of the standard deduction or itemized deductions 5,700 Taxable income ___________ The standard deduction of $5,700 exceeds itemized deductions of $3,000
  14. 14. 2010 Cengage Learning Gross income $40,000 Adjusted gross income 37,500 Greater of the standard deduction or itemized deductions 5,700 Taxable income $28,150 Taxable income = $37,500 – 5,700 – 3,650 exemption
  15. 15. <ul><li>Based on filing status and gross income </li></ul><ul><ul><li>Generally, if exemptions plus 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’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 and 2 on pages 1-7 and 1-8 </li></ul></ul></ul>2010 Cengage Learning
  16. 16. Failure to File Penalty <ul><li>The amount of the penalty ranges from 5 percent to 25 percent of the amount required to be shown on the return </li></ul><ul><li>Exception for delinquency in filing due to reasonable cause and not due to willful neglect </li></ul>
  17. 17. Failure to Pay Tax <ul><li>The penalty is one-half of 1% of the tax not paid, for each month (or part of a month) it remains unpaid, up to a maximum of 25% </li></ul><ul><li>The penalty increases to 1% per month the 10th day after notice of levy is given or the day on which notice and demand is made in the case of a jeopardy assessment. </li></ul>
  18. 18. <ul><li>Taxpayer must file if </li></ul><ul><ul><li>Owe any special taxes (See Figure 3 on page 1-8) </li></ul></ul><ul><ul><li>Received Advanced Earned Income Credit payments from employer </li></ul></ul><ul><ul><li>Had self-employment (SE) income >= $400 </li></ul></ul><ul><ul><li>Other situations outlined on Chart C </li></ul></ul>2010 Cengage Learning
  19. 19. <ul><li>Note: Must analyze each independent situation to determine if the taxpayers are required to file a return for 2009 </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 taxpayer owes social security taxes on unreported tips. </li></ul>2010 Cengage Learning
  20. 20. <ul><li>Taxpayer is single (age 31) and blind and has income of $9,950; is the taxpayer 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 income. </li></ul>2010 Cengage Learning
  21. 21. <ul><li>Husband (age 67) and wife (age 69) have income of $19,180 and MFJ; are the taxpayers 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 income. </li></ul>2010 Cengage Learning
  22. 22. <ul><li>Taxpayer 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 the taxpayer required to file? </li></ul><ul><li>Yes, because standard deduction = $5,700; exemption = 0 (as he’s claimed by parents). Income exceeds these amounts. </li></ul>2010 Cengage Learning
  23. 23. <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>2010 Cengage Learning
  24. 24. <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 has signed IRS/legal document, may still claim HOH even if dependency exemption shifted to ex-spouse </li></ul></ul>2010 Cengage Learning *See p. 1-10 for requirement for abandoned spouse
  25. 25. <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>2010 Cengage Learning
  26. 26. <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><ul><li>Marginal rate may exceed 35% when taxpayers are required to phase-out exemptions and deductions </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>2010 Cengage Learning
  27. 27. <ul><li>Provisions includes Making Work Pay Credit </li></ul><ul><ul><li>$400 ($800 MFJ) refundable credit on 2009 tax return </li></ul></ul><ul><ul><ul><li>Reduced by any automatic rebate received by certain taxpayers in 2009 </li></ul></ul></ul><ul><ul><ul><li>Reflected in new FIT withholding tables which directly infused cash into economy through increased wages </li></ul></ul></ul><ul><ul><ul><li>Phases-out $75,000 ($150,000 MFJ) </li></ul></ul></ul><ul><ul><ul><li>Complete Schedule M to calculate credit </li></ul></ul></ul>2010 Cengage Learning
  28. 28. <ul><li>Personal exemptions may be taken for self/spouse </li></ul><ul><li>Additional exemptions may be taken for individuals who are either </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 2009 each exemption = $3,650 </li></ul><ul><li>Exemption phased-out to $2,433 when AGI exceeds certain AGI thresholds </li></ul>2010 Cengage Learning
  29. 29. <ul><li>Dependency exemption allowed for child 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>2010 Cengage Learning
  30. 30. <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>2010 Cengage Learning
  31. 31. <ul><li>Dependency exemption may be granted for a qualifying relative (who is not a qualifying child). </li></ul><ul><li>Note: A taxpayer’s child who does not meet qualifying child test may meet qualifying relative test!! </li></ul>2010 Cengage Learning
  32. 32. <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>2010 Cengage Learning
  33. 33. 2010 Cengage Learning <ul><li>2009 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) $ 8,350 </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 2009 only, may add sales tax on qualified motor vehicle purchased after 2/16/09 and lesser of $500 (or $1,000 MFJ) or actual real estate taxes paid to standard deduction </li></ul>
  34. 34. 2010 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 2009. $2,000 earned income ( 2,000 ) standard deduction $0 taxable income Example 2: Tia is 18 and has dividend income of $1,500 (not earned) $1,500 dividend income ( 950 ) standard deduction $ 550 taxable income
  35. 35. 2010 Cengage Learning Basic Gain/Loss Model Amount Realized* - Adjusted Basis** Realized Gain/Loss *Sales Price - Sales Expenses **Cost - Accumulated Depreciation
  36. 36. <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>2010 Cengage Learning
  37. 37. <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>2010 Cengage Learning
  38. 38. 2010 Cengage Learning Facts: Noah purchased Sony AAA bonds in 2001 for $47,600. In 2009, 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. 2010 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. 2010 Cengage Learning