Income Taxation of Individuals

1
Income TaxationofIndividuals

• Chapter 11

2
Individual Income Tax Model

• Gross income
• Less Deductions for adjusted gross income
• Equals Adjusted Gross Income (AGI)
• Less Deductions from AGI (greater of
  itemized or standard deduction)
• Less Exemptions (personal dependency)
• Equals Taxable income

3
Tax Model (continued)

• Taxable income
• Times Tax rates
• Equals Gross income tax liability
• Less Tax credits
• Plus Additions to tax
• Less Tax prepayments
• Equals Net tax due or tax refund

4
Deductions For AGI

• Deductions discussed in previous chapters
• Retirement plan contributions including IRAs
• Moving expenses
• 50 of self-employment taxes
• Self-employed health insurance
• Alimony paid

5
Deductions For AGI

• Deductions discussed in this chapter
• Educator expenses
• Student loan interest expense
• Tuition and fees deduction
• Archer medical savings accounts (MSA)
• Penalty on early withdrawals of savings

6
Educator Expenses

• For kindergarten through 12th grade teachers
• Deduct up to 250 of unreimbursed expenses
  teachers pay for books, supplies, computer
  equipment, software, and other supplemental
  materials used in the classroom
• For tax years 2002 and 2003

7
Student Loan Interest

• Deduction for interest paid on qualified student
  loans incurred and used for tuition, fees, room,
  board, books, and supplies
• Deduction limit is 2,500
• Phases out with modified AGI of 50,000 - 65,000
  (100,000 - 130,000 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

8
Tuition Fees Deduction

• 3,000 deduction for 2002-2003 for tuition fees
  for taxpayer, spouse, and dependents
• Individuals who are claimed as dependents cannot
  take deduction on their own tax return
• No double benefit - no deduction if expense is
  deductible under any other provision (including
  education credits)
• Income limits apply (65,000 if single and
  130,000 if married filing jointly)

9
Tuition Fees Deduction

• For 2004 and 2005
• Deduction increases to 4,000 for singles with
  income below 65,000 (130,000 if married filing
  jointly)
• Deduction is 2,000 for singles with income
  65,000 - 80,000 (130,000 - 160,000 for joint
  filers)

10
Archer Medical Savings Account

• Taxpayers covered only by high-deductible medical
  insurance may deduct amounts set aside in MSA
• Contributions and earnings on MSAs are not taxed
  when withdrawn to pay medical expenses
• For 2003, qualified policies are those with
  deductibles of 1,700 - 2,500 for individuals
  (3,350 - 5,050 for families)
• Contributions limited to 65 of policy deductible
  for individuals (75 for families)
• Distributions not spent on qualifying expenses
  are included in income and subject to 15 penalty

11
Penalty on Early Withdrawals

• Penalties assessed on premature withdrawals from
  certificates of deposits or other savings
  accounts are deductible
• Gross interest income, unreduced by the penalty,
  is included in taxable income
• Deducting the penalty ensures that only net
  interest income is included in taxable income

12
Filing Status

• Taxpayers filing status determines standard
  deduction and tax rate schedule
• Marital status determined on the last day of the
  tax year
• Separated spouses are considered married until
  divorce becomes final

13
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 file separately, both must itemize
  deductions or both must use the standard deduction

14
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

15
Filing Status Unmarried

• Unmarried taxpayers file as
• Head of household - an unmarried person who
  provides more than half of the cost of
  maintaining a home in which a child or other
  qualifying relative lives for more than half the
  year
• Single

16
Head of Household

• Qualifying relatives
• Unmarried child who lives with the taxpayer for
  more than half of the taxable year (does not need
  to be taxpayers dependent)
• A parent of the taxpayer who is a dependent (does
  not need to live in taxpayer's home)
• Other qualifying relatives must live with the
  taxpayer for more than half the year and be a
  dependent

17
Head of Household

• Qualifying relatives include brothers, sisters,
  parents, grandparents, nieces, nephews, aunts and
  uncles (defined as brother or sister of father or
  mother)
• Cousins and more distant relatives are not
  included in the definition of qualifying relative

18
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 taxpayer
  provides more than half the cost of maintaining
  the home in which a dependent child lives
• An abandoned spouse uses head of household tax
  rates and standard deduction

19
Exemptions

• Each taxpayer (who is not a dependent) is
  entitled to one personal exemption
• Exemption deduction is 3,050 for 2003
• Additional exemptions allowed for each person who
  is considered a dependent
• Anyone who is claimed as a dependent cannot claim
  a personal exemption

20
Dependency Exemptions

• An individual qualifies as a dependent only if
  all 5 of the requirements are satisfied
• 1. Relative or member-of-household test
• 2. The support test
• 3. Gross income test
• 4. Joint return test
• 5. Citizenship or residency test

21
Relative or Member-of-Household Test

• The dependent must be either
• Qualifying relative or
• Member of taxpayer's household for the entire
  taxable year
• Qualifying relatives include child, grandchild,
  brother, sister, parent, grandparent, niece,
  nephew, aunt, and uncle

22
The Support Test

• Taxpayer must provide more than 50 of the
  dependent's total support
• Support 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
• Nontaxable income used for support must be
  included in support determination

23
Multiple Support Agreement

• Multiple support agreements allow one member of
  group of support providers to claim the exemption
  when
• Together the group meets the support test
• All other dependency tests are met
• Member who claims exemption must provide more
  than 10 of the total support

24
Gross Income Test

• The dependent's gross income from taxable sources
  must be less than the exemption amount (3,050
  for 2003)
• The gross income test is waived for
• Child of taxpayer who is under age 19 at year end
  or
• Child of taxpayer who is under age 24 at year end
  and was a full-time student for at least 5 months
  during the year

25
Phaseout of Exemptions

• Both personal and dependency exemptions are
  phased out at a rate of 2 (4 for MFS) for each
  2,500 (or fraction thereof) of AGI above
  thresholds
• 139,500 if single
• 174,400 if head of household
• 209,250 if married filing jointly
• 104,625 if married filing separately

26
Exemption Phaseout

• (1) (AGI threshold AGI)/2,500 Phaseout
  Factor (always round up here)
• (2) Phaseout Factor x 2 Phaseout Percentage
• (3) Exemption Amount x (1 Phaseout Percentage)
  Adjusted Exemption Deduction
• Once AGI exceeds the threshold AGI by more than
  122,500 (61,250 for MFS) the exemption
  deduction is completely phased out

27
2003 Tax Act Changes

• Standard deduction marriage penalty relief
• For 2003 and 2004 married filing jointly
  deduction increases to double the deduction for
  single individuals (increases from 7,950 to
  9,500 for 2003)
• Married filing separately use single amount
• After 2004 returns to present law

28
Standard Deductions

• Standard Deductions (after 2003 Tax Act)
• 9,500 married filing a joint return
• 4,750 married filing separately
• 7,000 head of household
• 4,750 single individual
• Add on to standard deduction if taxpayer elderly
  (age 65) or blind
• 1,150 if single or head of household
• 950 if married

29
Standard Deduction

• Dependents standard deduction limited to greater
  of
• (1) 750 or
• (2) Earned income 250 (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

30
Itemized Deductions

• Itemized deductions provide tax benefit only to
  the extent that, in total, they exceed the
  taxpayers standard deduction
• Taxpayers can maximize use of the standard
  deduction and itemized deductions by timing
  certain deductible payments

31
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 medical
  insurance costs

32
Medical Expenses

• Health insurance premiums for taxpayers and their
  dependents are deductible only if paid from
  after-tax income
• Premiums paid through an employer-sponsored
  cafeteria plan are not deductible
• Premiums for disability insurance and for loss of
  life, limb or income are not deductible
• Premiums for long-term care insurance are
  deductible subject to limits based on age

33
Taxes

• Deductible taxes include
• State, local, and foreign real property taxes
• State and local personal property taxes
• State, local, and foreign income taxes
• Other federal, state, local, and foreign taxes
  incurred in a business or other income-producing
  activity

34
Nondeductible Taxes

• Federal income taxes
• Employee's share of payroll taxes
• Federal excise taxes not incurred for business
• State and local sales taxes on goods for personal
  use
• Assessments on property

35
Interest Expense

• Deductible interest includes
• Student loan interest (deductible for AGI)
• Investment interest
• Home mortgage interest
• No deduction for most other personal interest
  such as interest on auto loans, life insurance
  loans, credit card debt, and delinquent tax
  payments

36
Investment Interest Expense

• Investment interest includes interest on loans to
  acquire or hold investment property and margin
  interest paid to a broker
• Investment interest expense is only deductible to
  the extent of net investment income
• Net investment income excess of investment
  income over investment expenses
• Excess is carried forward (indefinitely) subject
  to same limit in future years

37
Investment Interest Expense

• Investment income gross income from interest,
  annuities, and short-term capital gains from
  investment property
• Long-term capital gains or dividends taxed at
  favorable rates are excluded unless election made
  to forgo the favorable rate
• Investment expenses safe deposit box rental
  fees, investment counsel fees, brokerage account
  maintenance fees
• Use lesser of total investment expenses or net
  miscellaneous itemized deductions after reduction
  for 2 AGI floor

38
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 (combined limit for 2 homes) is
  deductible
• Acquisition debt includes mortgage to buy,
  construct, or improve the residence

39
Qualified Residence Interest

• Interest on up to 100,000 principal amount of
  home equity loan is deductible
• Loan proceeds can be spent for anything
• Points (loan origination fees) paid on home
  mortgages are deductible
• Points paid on refinancing must be amortized over
  life of loan

40
Charitable Contributions

• Congress allows individuals, corporations,
  estates and trusts deductions for charitable
  contributions to certain qualified organizations
• Partnerships and S corporations pass the
  contributions through to their partners and
  shareholders who claim the deductions on their
  own income tax returns

41
Charitable Contributions

• Qualified charitable organizations
• Governmental 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

42
Charitable Contributions

• No deduction allowed to the extent that valuable
  goods or services are received in return for the
  contribution
• Exception - contributors to universities who
  receive preferred rights to purchase tickets for
  university athletic events may deduct 80 of the
  amount of their contribution
• Individuals can deduct up to 50 of AGI
• Excess contributions carry forward up to 5 years

43
Charitable Contributions

• No deduction for contributions of the taxpayers
  services and rent-free use of the taxpayers
  property
• Out-of-pocket costs incurred related to volunteer
  work are deductible
• Property other than long-term capital gain
  property is valued at lesser of FMV or basis

44
LTCG Property Contributions

• LTCG property is valued at the higher FMV
• Tangible personalty given to a charity which does
  not use the property in its tax-exempt activity
  is valued at the lower adjusted basis
• LTCG property valued at FMV limited to 30 AGI
• 30 limit can be avoided (then 50 AGI limit
  applies) if taxpayer elects to use lower basis
• If made, election applies to all LTCG
  contributions that year

45
Charitable Contributions

• Stocks that have declined in value should be sold
  so that the loss can be claimed with the proceeds
  donated
• Fees incurred for appraisals of donated property
  may be deducted as miscellaneous itemized
  deductions

46
Casualty and Theft Losses

• Loss is the lesser of
• Assets adjusted basis or
• Decline in assets fair market value from the
  casualty
• Loss is reduced for any insurance proceeds
• 100 floor applies to each casualty
• Deductible only to extent total losses exceed 10
  of AGI

47
Miscellaneous Deductions

• Only excess over 2 AGI is deductible
• Unreimbursed employee business expenses
• Job hunting expenses (in searching for a new job
  in current line of business)
• Investment-related expenses
• Hobby expenses (up to hobby income)
• Tax preparation and planning advice

48
Phaseout ofItemized Deductions

• Total deductions phased out by 3 of AGI in
  excess of 139,500 in 2003 (69,750 if MFS)
• Exception - deductions not phased out for
• Medical expenses
• Investment interest
• Casualty and theft losses
• Total deductions are not reduced by more than 80
  regardless of type

49
2003 Tax Act Changes

• Individual income tax rates above 15 drop to
  25, 28, 33, and 35
• The 10 bracket expands
• For 2003 and 2004 to the first 7,000 of taxable
  income for single individuals and married filing
  separately (14,000 for married filing joint
  return)
• 15 bracket expands to relieve marriage tax
  penalty

50
2003 Tax Act New Rates

• For married filing joint return for 2003
• 10 on first 14,000 taxable income
• 15 on 14,001 - 56,800
• 25 on 56,801 - 114,650
• 28 on 114,651 - 174,700
• 33 on 174,701 - 311,950
• 35 over 311,950

51
2003 Tax Act New Rates

• For married filing separately for 2003
• 10 on first 7,000 taxable income
• 15 on 7,001 - 28,400
• 25 on 28,401 - 57,325
• 28 on 57,326 - 87,350
• 33 on 87,351 - 155,975
• 35 over 155,975

52
2003 Tax Act New Rates

• For single individuals for 2003
• 10 on first 7,000 taxable income
• 15 on 7,001 - 28,400
• 25 on 28,401 - 68,800
• 28 on 68,801 - 143,500
• 33 on 143,501 - 311,950
• 35 over 311,950

53
2003 Tax Act New Rates

• For head of household for 2003
• 10 on first 10,000 taxable income
• 15 on 10,001 - 38,050
• 25 on 38,051 - 98,250
• 28 on 98,251 - 159,100
• 33 on 159,101 - 311,950
• 35 over 311,950

54
Special Tax Rates

• 28 rate applies to LTCG from collectibles and
  Section 1202 small business stock
• 25 rate applies to unrecaptured Section 1250
  gain
• For capital assets sold or exchanged after May 5,
  2003 new rates apply
• 15 rate (instead of 20)
• 5 rate applies to taxpayers in 10 or 15 tax
  brackets
• Dividend income will be taxed using the new 15
  rate (5 for low-income taxpayers)

55
Credits vs. Deductions

• 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

56
Child Tax Credit

• 2003 Tax Act increased to 1,000 (from 600)
  nonrefundable tax credit for each qualifying
  child under age 17
• Qualifying children include the taxpayers 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

57
Education Credits

• Two elective nonrefundable tax credits are
  provided for college or vocational tuition and
  fees for the taxpayer, spouse, or dependents
• Hope Scholarship Credit 100 of first 1,000
  and 50 of second 1,000 tuition and fees for
  first 2 years only (maximum 1,500 per student)
• Lifetime Learning Credit 20 of up to 10,000
  tuition and fees (maximum 2,000 per taxpayer in
  2003)
• A student who is a dependent cannot claim the
  credit

58
Education Credits

• Expenses paid with a Pell Grant, scholarship, or
  employer-provided educational assistance do not
  qualify
• The election is separate for each student, so a
  parent may choose one credit for one child and a
  different credit for a second child
• Both credits phase out over modified AGI of
• 41,000 - 51,000 if single
• 83,000 - 103,000 if married filing jointly

59
Earned Income Credit

• To reduce the impact of payroll taxes for
  low-income individuals
• Credit is equal to a percentage of earned income
  below a maximum
• With one qualifying child maximum credit is
  2,547 (7,490 x 34)
• With two or more qualifying children maximum
  credit is 4,204 (10,510 x 40)
• Smaller credit available to taxpayers without
  children of 382 maximum (4,990 x 7.65)

60
Earned Income Credit

• This is a refundable credit
• Taxpayers with investment income of 2,600 or
  more are not eligible
• Anyone who can be claimed as a dependent is not
  eligible
• Must be a working taxpayer age 25 through 64

61
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
  4,000 for one qualifying child or 6,000 for 2
  or more qualifying children
• 35 for AGI not exceeding 15,000
• Reduced by 1 for each 2,000 (or fraction
  thereof) AGI exceeds 15,000
• 20 for AGI exceeding 43,000

62
Retirement Contributions Credit

• To encourage participation by low-income wage
  earners credit for up to 2,000 contributed to
  employer plans or IRAs
• Credit varies with AGI
• 50 credit for joint filers with AGI up to
  30,000 (15,000 if single)
• 20 for joint filers with AGI of 30,000 -
  32,500 (15,000 - 16,250 if single)
• 10 for joint filers with AGI of 32,500 -
  50,000 (16,250 - 25,000 if single)
• Dependents or full-time students are not eligible

63
Excess Payroll Tax Credit

• Taxpayers working for more than one employer
  during the year with earnings exceeding the
  Social Security ceiling (87,000 for 2003)
  usually have too much tax withheld
• Employee is allowed a credit for any excess
  Social Security taxes withheld

64
Alternative Minimum Tax

• An alternative tax 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

65
AMT Model

• Taxable income
• Plus/minus Adjustments to taxable income
• Plus Tax preferences
• Less Allowable exemptions
• Equals Alternative minimum taxable income
• Times AMT tax rates
• Plus Tentative minimum tax (TMT)
• Less Regular income tax
• Equals AMT

66
AMT Exemptions

• 2003 Tax Act increased AMT exemptions for 2003
  and 2004 to
• 58,000 if married filing jointly (was 49,000)
• 29,000 if married filing separately (was
  24,500)
• 40,250 if single or head of household (was
  35,750)
• Exemptions begin to phase out when AMTI reaches
  112,500 for singles and 150,000 for married
  filing jointly (75,000 if MFS)

67
Alternative Minimum Tax

• Itemized deductions are different from those
  calculated for regular income tax
• Medical expenses must exceed 10 AGI
• Taxes, home equity loan interest, and
  miscellaneous itemized deductions are not
  deductible
• Tax preferences that are added include
• Nontaxable interest on private activity bonds
• Bargain element of incentive stock options

68
Payment of Income Tax

• Estimated quarterly payments are made by persons
  with large amounts of income from sources not
  subject to withholding
• Due on April 15, June 15, September 15 of current
  year and January 15 of following year
• If the tax paid by April 15 is not at least 90
  of the total tax owed, a penalty may be charged
  (unless balance due is less than 1,000)

69
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
• 7,800 in 2003 for a single individual
• Returns should be filed if
• Self-employed with 400 of net SE earnings
• Children with unearned income over 750
• Married filing separately if income over 3,050

70
The End