Chapter 3
Tax Formula and Tax
Determination;
An Overview of Property
Transactions
Individual Income Taxes
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1
The Big Picture (slide 1 of 2)
• Polly maintains a household in which she lives with her
– Unemployed husband (Nick),
– Stepdaughter (Paige), and
– A family friend (Maude).
• She provides more > ½ the support of both Paige and Maude.
– Maude was fatally injured in an automobile accident in February
• Polly paid for her hospitalization and funeral expenses.
– Paige, an accomplished gymnast, graduated from high school last year.
• Paige has a part-time job but spends most of her time training and looking
for an athletic scholarship to the ‘‘right’’ college.
2
The Big Picture (slide 2 of 2)
• In March, Nick left for parts unknown and has not
been seen or heard from since.
• Polly sold her wedding rings to a cousin who was
getting married.
– The rings cost $11,800.
– The rings were sold for their approximate value of $9,000.
• Based on these facts, what are Polly’s income tax
concerns for the current year?
– Read the chapter and formulate your response.
3
Tax Formula
Concept Summary 3.1
4
Income -Broadly Conceived
• Includes all the taxpayer’s income, both
taxable and nontaxable
– Essentially equivalent to gross receipts
• It does not include a return of capital or receipt of
borrowed funds
5
Partial List of Exclusions
from Gross Income
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Accident insurance proceeds
Annuities (cost element)
Bequests
Child support payments
Cost-of-living allowance (for
military)
Damages for personal injury or
sickness
Gifts received
Group term life insurance, premium
paid by employer (for coverage up to
$50,000)
Inheritances
Interest from state and local (i.e.,
municipal) bonds
Life insurance paid on death
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Meals and lodging (if furnished for
employer’s convenience)
Military allowances
Minister’s dwelling rental value
allowance
Railroad retirement benefits (to a
limited extent)
Scholarship grants (to a limited
extent)
Social Security benefits (to a limited
extent)
Unemployment compensation (to a
limited extent)
Veterans’ benefits
Welfare payments
Workers’ compensation benefits
Exhibit 3.1
6
Gross Income
• The Internal Revenue Code defines gross
income broadly as ‘‘except as otherwise
provided . . . , all income from whatever
source derived’’
• Gross income does not include unrealized
gains
7
Partial List of Gross Income Items
(slide 1 of 2)
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Alimony
Annuities (income element)
Awards
Back pay
Bargain purchase from employer
Bonuses
Breach of contract damages
Business income
Clergy fees
Commissions
Compensation for services
Death benefits
Debts forgiven
Director’s fees
• Dividends
• Embezzled funds
• Employee awards (in certain
cases)
• Employee benefits (except certain
fringe benefits)
• Estate and trust income
• Farm income
• Fees
• Gains from illegal activities
• Gains from sale of property
• Gambling winnings
• Group term life insurance,
premium paid by employer (for
coverage over $50,000)
Exhibit 3.2
8
Partial List of Gross Income Items
(slide 2 of 2)
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Hobby income
Interest
Jury duty fees
Living quarters, meals (unless
furnished for employer’s
convenience)
Mileage allowance
Military pay (unless combat pay)
Notary fees
Partnership income
Pensions
Prizes
Professional fees
Punitive damages
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Rents
Rewards
Royalties
Salaries
Severance pay
Strike and lockout benefits
Supplemental unemployment
benefits
Tips and gratuities
Travel allowance (in certain
cases)
Treasure trove (found property)
Wages
Exhibit 3.2
9
Deductions - Individual Taxpayers
• Individual taxpayers have two categories of
deductions:
– Deductions for adjusted gross income (AGI)
– Deductions from adjusted gross income
10
Deductions For AGI (slide 1 of 2)
• Sometimes known as above-the-line
deductions
– On the tax return, they are taken before the ‘‘line’’
designating AGI
11
Deductions For AGI (slide 2 of 2)
• Deductions for AGI include:
– Ordinary and necessary expenses incurred in a trade or
business
– One-half of self-employment tax paid
– Alimony paid
– Certain payments to an IRA and Health Savings Accounts
– Unreimbursed moving expenses
– Fees for college tuition and related expenses
– Interest on student loans
– The capital loss deduction, and
– Others
12
Adjusted Gross Income (AGI)
• AGI is an important subtotal
– Serves as the basis for computing percentage
limitations on certain itemized deductions such as
• Medical expenses
• Charitable contributions
• Certain casualty losses
– e.g., Medical expenses are deductible only to the
extent they exceed 10% of AGI (7.5% if ≥ age 65)
• This limitation might be described as a 10% “floor”
under the medical expense deduction
13
Deductions From AGI (slide 1 of 3)
• Deductions from AGI include:
– The greater of:
• Itemized deductions, or
• The standard deduction
– Personal and dependency exemptions
14
Deductions From AGI (slide 2 of 3)
• A partial list of itemized deductions includes:
– Medical expenses (in excess of 10% of AGI)
• In excess of 7.5% if ≥ age 65
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–
–
–
Certain taxes and interest
Charitable contributions
Casualty Losses (in excess of 10% of AGI)
Deductions for expenses related to
• The production or collection of income, and
• The management of property held for the production of income
– Certain miscellaneous itemized deductions (in excess of
2% of AGI)
15
Deductions From AGI (slide 3 of 3)
• The standard deduction is the sum of two
components:
– Basic standard deduction
• Amount allowed is based on taxpayer’s filing status
– Additional standard deductions
• Available for taxpayers who are
– Age 65 or over, and/or
– Blind
• Two additional standard deductions are allowed for a taxpayer who
is age 65 or over and blind
• Amount allowed depends on filing status
16
Standard Deduction (slide 1 of 2)
• The basic standard deduction (BSD) amount
depends on filing status of taxpayer
EXHIBIT 3.4
17
Standard Deduction (slide 2 of 2)
• Additional standard deduction (ASD)
– For taxpayers age 65 or older and/or legally blind
EXHIBIT 3.5
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Determining Standard Deduction
• Examples (2015 tax year):
– Taxpayer is single, blind, and age 65 or older
• SD = $6,300 (BSD) + $1,550 (ASD) + $1,550 (ASD) =
$9,400
– Taxpayers are married, filing jointly, one blind,
and both age 65 or older
• SD = $12,600 (BSD) + $1,250 (ASD) + $1,250 (ASD)
+ $1,250 (ASD) = $16,350
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Taxpayers Ineligible For Standard
Deduction
• Certain taxpayers cannot use the SD:
– Married, filing separately, when either spouse
itemizes deductions
– Nonresident aliens
– Individual filing return for tax year of less than 12
months because of change in annual accounting
period
20
SD Limit For Person
Claimed as Dependent
• Individual claimed as dependent has a BSD in
2015 limited to the greater of:
– $1,050 or
– $350 plus earned income (but not exceeding
normal BSD)
• ASD amount(s) still available
21
Examples of SD Limit (slide 1 of 2)
• Dependent’s SD (2015 tax year):
– A blind child who earns $200 and is claimed by
parents as a dependency exemption
• SD = $1,050 (BSD) + $1,550 (ASD) = $2,600
– A child who earns $1,500 and is claimed by
parents as a dependency exemption
• SD = $1,850 [BSD equal to greater of $1,050 or ($350 +
$1,500 earned income)]
22
Examples of SD Limit (slide 2 of 2)
• Examples of dependent’s SD (2015 tax year)
– A child who earns $6,100 and is claimed by
parents as a dependency exemption
• SD = $6,300 [BSD equal to greater of $1,050 or ($350 +
$6,100 earned income) limited to the $6,300 standard
deduction for a single taxpayer]
23
Personal and Dependency
Exemption Amounts
• Amounts
– 2015: $4,000 per exemption
– 2014: $3,950 per exemption
• Personal and dependency exemptions
– One per taxpayer (two personal exemptions when
married, filing jointly) and for each dependent
• Exception: Individual claimed as dependent by another
taxpayer does not receive a personal exemption
24
Personal and Dependency
Exemptions In Year Of Death
• Personal exemption allowed on joint return for
spouse who dies during the year
– Example: Tom and Betty were married in 1990.
Tom dies on February 1, 2015. A personal
exemption may be claimed for Tom on the
taxpayers’ 2015 joint return.
25
Dependency Exemptions (slide 1 of 2)
• A dependency exemption is available for one
who is either a qualifying child or a qualifying
relative
– A qualifying child must meet the following tests:
•
•
•
•
Relationship
Abode
Age, and
Support
26
Dependency Exemptions (slide 2 of 2)
• Congress has tried to establish a uniform
definition of qualifying child for purposes of
the:
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Dependency exemption
Head-of-household filing status
Earned income tax credit
Child tax credit
Credit for child and dependent care expenses
27
Relationship Test
• The child must be the taxpayer’s:
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Son or daughter
Stepson or stepdaughter
Brother or sister
Stepbrother or stepsister
Half brother or half sister, or
A descendant of such individual (e.g., grandchildren,
nephews, nieces)
• A child who has been adopted, or whose adoption is
pending, qualifies
• A foster child may also qualify
28
Abode Test
• A qualifying child must live with the taxpayer
for more than half of the year
– Temporary absences from the household due to
special circumstances (e.g., illness, education) are
not considered
29
Age Test
• The child must be under age 19 or under age
24 in the case of a student
– A student is a child who, during any part of five
months of the year, is enrolled full time at a school
or government-sponsored on-farm training course
– Individuals who are disabled are not subject to the
age test
30
The Big Picture - Example 14
Dependency Exemptions
• Return to the facts of The Big Picture on p. 3-1.
• Does Paige meet the requirements of a qualifying
child so Polly can claim a dependency exemption for
her?
– Paige satisfies the relationship and abode tests, but the
answer to the age test remains unclear.
– Since she is not a full-time student or disabled, she must be
under 19 to meet the age test.
• Unfortunately, the facts given do not provide Paige’s precise age.
31
Support
• To be a qualifying child, the individual must
not be self-supporting
– Cannot provide more than one-half of his or her
own support
– In the case of a full-time student, scholarships are
not considered to be support
32
Tiebreaker Rules
• In situations where a child may be a qualifying
child for more than one person
– Tiebreaker rules specify which person has priority
in claiming the dependency exemption
Concept
Summary 3.2
33
Qualifying Relative
• In order to claim a dependency exemption for
a qualifying relative, the following tests must
be met:
– Relationship
– Gross income
– Support
34
Relationship Test
• The relationship test for a qualifying relative is
more expansive than for a qualifying child.
Also included are the following relatives:
– Lineal ascendants (e.g., parents, grandparents)
– Collateral ascendants (e.g., uncles, aunts)
– Certain in-laws (e.g., son-, daughter-, father-,
mother-, brother-, and sister-in-law)
• The relationship test also includes unrelated
parties who live with the taxpayer
35
The Big Picture - Example 19
Dependency Exemptions
• Return to the facts of The Big Picture on p. 3-1.
• Is Maude a qualifying relative?
– Although Maude is unrelated to Polly, she qualifies as
Polly’s dependent by being a member of the household.
– Since Maude is a dependent, Polly can also claim the
medical expenses she paid on Maude’s behalf.
• The funeral expenses are not deductible.
• Although Maude lived for only two months, the full amount of the
dependency exemption is allowed and does not have to be
apportioned.
36
Gross Income Test
• Dependent’s gross income must be less than
the exemption amount ($4,000 for 2015)
37
The Big Picture - Example 22
Dependency Exemptions
• Return to the facts of The Big Picture on p. 3-1.
• Assuming that Paige is not a qualifying child, can she
be a qualifying relative for dependency exemption
purposes?
– She meets the relationship and support tests, but what about
the gross income test?
– If her income from her part-time job is less than $4,000,
she does qualify and can be claimed by Polly as a
dependent.
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Support Test
• Taxpayer must provide more than 50% of the
qualifying relative’s support
– Only amounts expended are considered in the
support test
– Scholarships are not considered in the support test
• Two exceptions to the support test:
– Multiple support agreements
– Children of divorced parents
39
Multiple Support Agreements
• Allows one member of a group providing >
50% of support to claim individual even
though no one person provides > 50% support
– Eligible parties must provide > 10% of support
– Each eligible party must meet all other dependency
requirements
• Example - Allows children of elderly parent to
claim exemption for parent when none
individually meets the 50% support test
40
Children of Divorced Parents
• Special rules apply if the parents meet the following
conditions:
– They would have been entitled to the dependency exemption had they
been married and filed a joint return
– They have custody (either jointly or singly) of the child for more than
half of the year
• Under the general rule, the parent having custody of the child
for the greater part of the year (i.e., the custodial parent) is
entitled to the dependency exemption
– General rule does not apply if
• A multiple support agreement is in effect
• Custodial parent issues a waiver in favor of the noncustodial parent
41
Other Rules for
Dependency Exemptions
• In addition to fitting into either the qualifying
child or the qualifying relative category, a
dependent must also meet:
– The joint return, and
– The citizenship or residency tests
42
Joint Return Test
• Dependent cannot file a joint return with
spouse unless:
– Filing solely for refund of tax withheld
– No tax liability exists for either spouse
– Neither spouse required to file return
43
Citizenship or Residency Test
• Dependent must be a U.S. citizen or a resident
of U.S., Canada, or Mexico for some part of
the calendar year in which the taxpayer’s tax
year begins
– An exception provides that an adopted child need
not be a citizen or resident of the U.S. (or a
contiguous country) as long as his or her principal
abode is with a U.S. citizen
44
Phaseout of Exemptions
• Personal and dependency exemptions are phased out
by 2% for each $2,500 (or fraction thereof) by which
the taxpayer’s AGI exceeds the following threshold
amounts
– For a married taxpayer filing separately, the phaseout is 2%
for each $1,250 (or fraction thereof)
C1-45
Child Tax Credit
• $1,000 tax credit is allowed for each dependent
child under the age of 17
– Qualifying child includes stepchildren and eligible
foster children
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Filing Requirements (slide 1 of 2)
• General Rule: Tax return must be filed if gross
income is ≥ the sum of the standard deduction
and exemption amount
• ASD for blind does not apply for this determination
– Special rules apply for dependents and selfemployed taxpayers
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Filing Requirements (slide 2 of 2)
• Tax return of an individual is due on or before
the 15th day of the 4th month after taxpayer’s
year end
– Most individuals are calendar year taxpayers, thus,
due date is April 15
• May obtain a 6 month extension of time to file
– Excuses a taxpayer from penalty for failure to file,
not from penalty for failure to pay
• If more tax is owed, extension request (Form 4868)
should be accompanied by check for balance of tax due
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Filing Status
• There are 5 filing statuses
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Single
Married, filing jointly
Surviving spouse (qualifying widow or widower)
Head of household
Married, filing separately
• Filing status affects tax rate brackets, standard
deduction, and other amounts
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Single Filing Status
• Includes a taxpayer who is unmarried or
separated from spouse by a divorce decree or
separate maintenance agreement and does not
qualify for another filing status
– Marital status is determined as of the last day of
the tax year
• When a spouse dies during the year, marital status is
determined as of the date of death
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Married Filing Jointly
(MFJ) Filing Status
• Married as of last day of taxable year, or
• Spouse dies during taxable year
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Surviving Spouse Filing Status
• Same tax rate brackets as married, filing jointly
• File as surviving spouse for 2 years after death of
spouse if taxpayer maintains a home in which a
dependent child lives
– For the year of death, surviving spouse is treated as being
married
• Thus, a joint return can be filed if the deceased spouse’s executor
agrees
52
Married Filing Separately Filing Status
• Married but not filing a return with spouse and
not abandoned spouse
53
Head of Household (HH) Filing Status
• Must be unmarried as of end of year or an
abandoned spouse
• Must pay > half the cost of maintaining a
household which is the principal home of a
dependent for > half of tax year
– A dependent must satisfy either the qualifying
child or the qualifying relative category
• A qualifying relative must also meet the relationship test
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The Big Picture - Example 34
Head-of-Household Filing Status
• Return to the facts of The Big Picture on p. 3-1.
• Assuming that Polly can be treated as single
(i.e., not married), can Maude qualify Polly for
head-of-household filing status?
– The answer is no.
– Even though Maude can be claimed as Polly’s
dependent, she does not meet the relationship test.
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Exception to the HH Requirements
• HH may be claimed if taxpayer maintains a
separate home for his or her parents
– At least one parent must qualify as a dependent
56
Abandoned Spouse
• Allows married taxpayer to file as Head of
Household if taxpayer:
– Does not file a joint return
– Paid > half the cost of maintaining a home
– Spouse did not live in home during last 6 months
of tax year
– Home was principal residence of taxpayer’s child
for > half of year
• Can claim child as a dependent
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The Big Picture - Example 37
Abandoned Spouse Filing Status
• Return to the facts of The Big Picture on p. 3-1.
• Can Polly qualify as an abandoned spouse?
– Yes, if she can claim Paige as a dependent—either
as a qualifying child or as a qualifying relative.
– If so, Polly can use head-of-household filing
status.
– If not, her filing status is married person filing
separately.
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Taxes Rates
• Tax liability is computed using either the Tax Table
method or the Tax Rate Schedule method
– Most taxpayers must use the Tax Tables
– Certain taxpayers may not use the Tax Table method
including:
• An individual who files a short period return
• Individuals whose taxable income exceeds the maximum (ceiling)
amount in the Tax Table
– The 2014 Tax Table applies to taxable income below $100,000
• An estate or trust
• For 2015 the tax rates are 10%, 15%, 25%, 28%,
33%, 35%, and 39.6%
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Kiddie Tax (slide 1 of 4)
• Net unearned income (NUI) of a child is taxed at
parents’ rate
– Child must be under age 19 at end of year (or under age 24
if a full-time student)
– NUI generally equals unearned income less $2,100 (2015
tax year)
• The kiddie tax does not apply if
– The child has earned income that exceeds half of his or her
support,
– If the child is married and files a joint return, or
– If both parents are deceased
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Kiddie Tax (slide 2 of 4)
• Unearned income includes:
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–
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–
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–
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Taxable interest
Dividends
Capital gains
Rents
Royalties
Pension and annuity income, and
Unearned income from trusts
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Kiddie Tax (slide 3 of 4)
• Computing NUI for Kiddie Tax for 2015:
– Unearned income
– Less: $1,050
– Less: The greater of:
i) $1,050, or
ii) Allowable itemized deductions connected
with production of unearned income
– Equals: net unearned income
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Kiddie Tax (slide 4 of 4)
• Net unearned income taxed at parents’ rate
– Remainder of taxable income taxed at child’s rate
• Two options for computing the tax
– A separate return may be filed for the child
• The tax on net unearned income (referred to as the allocable
parental tax) is computed as though the income had been included
on the parents’ return
– Form 8615 is used to compute the tax
– The parents may elect to report child’s income on their own
return
• Certain requirements must be met
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Gains and Losses from Property
Transactions (slide 1 of 3)
• In order for gains (losses) to be recognized
(included in gross income), they must be
realized:
– Amount realized - adjusted basis = Realized gain
(loss)
• Amount realized = selling price - costs of disposition
• Adjusted basis = cost + capital additions - cost recovery
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Gains and Losses from Property
Transactions (slide 2 of 3)
• All realized gains are recognized unless a
specific tax provision provides otherwise (e.g.,
nontaxable exchanges)
• Realized losses may or may not be recognized
depending on the circumstances
– Generally, losses on the sale or disposition of
personal use property are not recognized
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Gains and Losses from Property
Transactions (slide 3 of 3)
• Once recognized gains or losses have been
determined, they must be classified as
ordinary or capital
– Ordinary gains are fully taxable
– Ordinary losses are fully deductible
• Capital gains and losses are subject to special
tax treatment
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Gains and Losses from Capital Asset
Transactions (slide 1 of 2)
• Capital assets are defined as any property other
than:
– Inventory,
– Accounts Receivable, and
– Depreciable property or real property used in a
business
• Most personal use assets owned by individuals
are capital assets
– Losses on these assets are not deductible
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Gains and Losses from Capital Asset
Transactions (slide 2 of 2)
• Gains and losses from capital asset
transactions must be netted
– Net gains and losses by holding period
– If excess losses result, they are shifted to the
category carrying the highest tax rate
68
Max Tax Rates for Net
Capital Gains of Individuals
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Treatment of Capital Losses
• Net capital losses of individuals are deductible
for AGI up to $3,000 yearly
– Excess capital losses are carried over to the next
tax year
– When carried over, capital losses retain their
classification as short- or long-term
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The Big Picture - Example 48
Treatment Of Net Capital Loss
• Return to the facts of The Big Picture on p. 3-1.
• Polly’s sale of her wedding rings resulted in a
realized capital loss of $2,800
– [$9,000 (selling price) - $11,800(cost basis)].
• Because they were personal use property,
Polly cannot deduct the loss.
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Refocus On The Big Picture (slide 1 of 4)
• Polly’s major concern is her filing status.
– If she qualifies as an abandoned spouse, she is
entitled to file as head of household.
• If not, she is considered to be a married person filing
separately.
– In order to be an abandoned spouse, Polly must be
able to claim Paige as a dependent.
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Refocus On The Big Picture (slide 2 of 4)
• To be a dependent, Paige must meet the requirements
of a qualifying child or a qualifying relative.
– For qualifying child purposes, Paige must meet either
• The age test (i.e., under age 19), or
• The full-time student (under age 24) test.
– Paige is not a full-time student - is she under age 19?
– If so, she is a qualifying child.
– If Paige is not a qualifying child, is she a qualifying
relative?
– Here, the answer depends on meeting the gross income test.
– How much did Paige earn from her part-time job?
» If her earnings are under $4,000, she satisfies the gross income
test.
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Refocus On The Big Picture (slide 3 of 4)
• If Paige can be claimed as a dependent, Polly is an
abandoned spouse entitled to head-of-household
filing status.
– If not, she is a married person filing separately.
• Maude can be claimed as Polly’s dependent because
she is a member of the household.
– It does not matter that she died in February
• The dependency exemption amount need not be apportioned and is
allowed in full.
– Because Maude is her dependent, Polly can claim the
medical expenses she paid on Maude’s behalf.
• The funeral expenses, however, are not deductible.
74
Refocus On The Big Picture (slide 4 of 4)
• Does Maude qualify Polly for head-ofhousehold filing status?
– No—although she is a dependent, Maude does not
meet the relationship test.
• The sale of the wedding rings results in a
capital loss of $2,800 ($9,000 – $11,800).
– Because the loss is for personal use property, it
cannot be claimed for tax purposes.
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If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
trippedr@oneonta.edu
SUNY Oneonta
© 2016 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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