Chapter 3
Tax Determination; Personal and
Dependency Exemptions; An Overview
of Property Transactions
Individual Income Taxes
Copyright ©2009 Cengage Learning
Individual Income Taxes
C3-1
Tax Formula (slide 1 of 2)
Income (broadly conceived)
Less:Exclusions
Gross Income
Less:Deductions for AGI
Adjusted Gross Income (AGI)
Less:The greater ofTotal itemized deductions
or the standard deduction
Personal & dependency exemptions
Taxable Income
$x,xxx
(x,xxx)
$x,xxx
(x,xxx)
$x,xxx
(x,xxx)
(x,xxx)
$x,xxx
FIGURE 3–1
Individual Income Taxes
C3-2
Tax Formula (slide 2 of 2)
Tax on taxable income (see Tax Tables or
Tax Rate Schedules)
Less: Tax credits (including income
taxes withheld and prepaid)
Tax due (or refund)
$ x,xxx
(xxx)
$ xxx
FIGURE 3–1
Individual Income Taxes
C3-3
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
Individual Income Taxes
C3-4
Partial List of Exclusions
from Gross Income
•
•
•
•
•
•
•
•
•
•
•
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
•
•
•
•
•
•
•
•
•
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)
Veterans’ benefits
Welfare payments
Workers’ compensation benefits
Exhibit 3-1
Individual Income Taxes
C3-5
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
Individual Income Taxes
C3-6
Partial List of Gross Income Items
(slide 1 of 2)
•
•
•
•
•
•
•
•
•
•
•
•
•
•
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
•
•
•
•
•
•
•
•
•
•
•
•
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
Exhibit 3-2
Individual Income Taxes
C3-7
Partial List of Gross Income Items
(slide 2 of 2)
•
•
•
•
•
•
•
•
•
•
•
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)
•
•
•
•
•
•
•
•
•
•
Rents
Rewards
Royalties
Salaries
Severance pay
Strike and lockout benefits
Supplemental unemployment
benefits
Tips and gratuities
Travel allowance (in certain cases)
Wages
Exhibit 3-2
Individual Income Taxes
C3-8
Deductions - Individual Taxpayers
• Individual taxpayers have two categories of
deductions:
– Deductions for adjusted gross income (AGI)
– Deductions from adjusted gross income
Individual Income Taxes
C3-9
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
Individual Income Taxes
C3-10
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
– Moving expenses
– Fees for college tuition and related expenses
– Interest on student loans
– The capital loss deduction, and
– Others
Individual Income Taxes
C3-11
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 7.5% of AGI
• This limitation might be described as a 7.5% “floor” under the
medical expense deduction
Individual Income Taxes
C3-12
Deductions From AGI (slide 1 of 3)
• Deductions from AGI include:
– The greater of:
• Itemized deductions, or
• The standard deduction
– Personal and dependency exemptions
Individual Income Taxes
C3-13
Deductions From AGI (slide 2 of 3)
• A partial list of itemized deductions includes:
–
–
–
–
–
Medical expenses (in excess of 7.5% of AGI)
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)
Individual Income Taxes
C3-14
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
– Blind
• Two additional standard deductions are allowed for a taxpayer
who is age 65 or over and blind
• Amount allowed depends on filing status
Individual Income Taxes
C3-15
Standard Deduction
(slide 1 of 2)
• The basic standard deduction (BSD) amount
depends on filing status of taxpayer
Filing status
Single
MFJ, SS
HH
MFS
2007
$5,350
10,700
7,850
5,350
2008 .
$5,450
10,900
8,000
5,450
TABLE 3–1
Individual Income Taxes
C3-16
Standard Deduction
(slide 2 of 2)
• Additional standard deduction (ASD)
– For taxpayers age 65 or older and/or legally
blind
Filing Status
Single
MFJ, SS
HH
MFS
TABLE 3–2
Individual Income Taxes
2007
$1,300
1,050
1,300
1,050
2008 .
$1,350
1,050
1,350
1,050
C3-17
Determining Standard Deduction
• Examples (2008 tax year):
– Taxpayer is single, blind, and age 65 or older
• SD = $5,450 (BSD) + $1,350 (ASD) + $1,350
(ASD) = $8,150
– Taxpayers are married, filing jointly, one blind,
and both age 65 or older
• SD = $10,900 (BSD) + $1,050 (ASD) + $1,050
(ASD) + $1,050 (ASD) = $14,050
Individual Income Taxes
C3-18
Personal and Dependency
Exemption Amounts
• Amounts
– 2007: $3,400 per exemption
– 2008: $3,500 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
Individual Income Taxes
C3-19
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
Individual Income Taxes
C3-20
SD Limit For Person
Claimed as Dependent
• Individual claimed as dependent has a BSD
limited to the greater of:
– $900 or
– $300 plus earned income (but not exceeding
normal BSD)
• ASD amount(s) still available
Individual Income Taxes
C3-21
Examples of SD Limit (slide 1 of 2)
• Dependent’s SD (2008 tax year):
– A blind child who earns $200 and is claimed by
parents as a dependency exemption
• SD = $900 (BSD) + $1,350 (ASD) = $2,250
– A child who earns $1,500 and is claimed by
parents as a dependency exemption
• SD = $1,800 [BSD equal to greater of $900 or ($300
+ $1,500 earned income)]
Individual Income Taxes
C3-22
Examples of SD Limit (slide 2 of 2)
• Examples of dependent’s SD (2008 tax
year)
– A child who earns $5,500 and is claimed by
parents as a dependency exemption
• SD = $5,450 [BSD limited to normal amount]
Individual Income Taxes
C3-23
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, 2008. A personal
exemption may be claimed for Tom on the
taxpayers’ 2008 joint return.
Individual Income Taxes
C3-24
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
Individual Income Taxes
C3-25
Dependency Exemptions (slide 2 of 2)
• One objective of the Working Families Tax
Relief Act of 2004 (WFTRA of 2004)
– Establish a uniform definition of qualifying
child for purposes of the:
•
•
•
•
•
Dependency exemption
Head-of-household filing status
Earned income tax credit
Child tax credit
Credit for child and dependent care expenses
Individual Income Taxes
C3-26
Relationship Test
• The child must be the taxpayer’s:
–
–
–
–
–
–
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
Individual Income Taxes
C3-27
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
Individual Income Taxes
C3-28
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
Individual Income Taxes
C3-29
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
Individual Income Taxes
C3-30
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
Individual Income Taxes
C3-31
Qualifying Relative
• In order to claim a dependency exemption
for a qualifying relative, the following tests
must be met:
– Relationship
– Gross income
– Support
Individual Income Taxes
C3-32
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
Individual Income Taxes
C3-33
Gross Income Test
• Dependent’s gross income must be less than
the exemption amount ($3,500 for 2008)
Individual Income Taxes
C3-34
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
Individual Income Taxes
C3-35
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
Individual Income Taxes
C3-36
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
Individual Income Taxes
C3-37
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
Individual Income Taxes
C3-38
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
Individual Income Taxes
C3-39
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
Individual Income Taxes
C3-40
Phase-out of Exemptions (slide 1 of 2)
Applies when taxpayer’s AGI in 2008 exceeds:
•
•
•
•
$239,950 for married, filing jointly, or surviving spouse
$199,950 for head of household
$159,950 for single
$119,975 for married, filing separately
• The phase-out of exemptions is being repealed in
two stages and will not be complete until 2010
– The exemption phaseout remains at two-thirds for 2006
and 2007 and at one-third for 2008 and 2009
Individual Income Taxes
C3-41
Phase-out of Exemptions (slide 2 of 2)
• Exemptions deduction is reduced by 2% for
every $2,500 ($1,250 for MFS), or part
thereof, that AGI exceeds threshold
amounts
– The amount of the phased-out exemptions is
then multiplied by 1/3 (the reduction-ofphaseout fraction) for tax years 2008 and 2009
Individual Income Taxes
C3-42
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
Individual Income Taxes
C3-43
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 2007 Tax Table applies to taxable income below $100,000
• An estate or trust
• For 2008 the tax rates are 10%, 15%, 25%, 28%,
33%, and 35%
Individual Income Taxes
C3-44
Kiddie Tax (slide 1 of 4)
• Net unearned income (NUI) of child is
taxed at parents’ rate
– Child must be under age 19 at end of year
– NUI generally equals unearned income less
$1,800 (2008 tax year)
Individual Income Taxes
C3-45
Kiddie Tax (slide 2 of 4)
• Unearned income includes:
–
–
–
–
–
–
–
Taxable interest
Dividends
Capital gains
Rents
Royalties
Pension and annuity income, and
Unearned income from trusts
Individual Income Taxes
C3-46
Kiddie Tax (slide 3 of 4)
• Computing NUI for Kiddie Tax:
Unearned income
Less: $900
Less: The greater of:
i) $900, or
ii) Allowable itemized deductions connected
with production of unearned income
Equals: net unearned income
Individual Income Taxes
C3-47
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
Individual Income Taxes
C3-48
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
Individual Income Taxes
C3-49
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
Individual Income Taxes
C3-50
Filing Status
• There are 5 filing statuses
–
–
–
–
–
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
Individual Income Taxes
C3-51
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
Individual Income Taxes
C3-52
Married Filing Jointly
(MFJ) Filing Status
• Married as of last day of taxable year, or
• Spouse dies during taxable year
Individual Income Taxes
C3-53
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
Individual Income Taxes
C3-54
Married Filing Separately Filing Status
• Married but not filing a return with spouse
and not abandoned spouse
Individual Income Taxes
C3-55
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 more than 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
Individual Income Taxes
C3-56
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
Individual Income Taxes
C3-57
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
Individual Income Taxes
C3-58
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:
– Realized gain (loss) = amount realized - adjusted basis
• Amount realized = selling price - costs of disposition
• Adjusted basis = cost + capital additions - cost recovery
Individual Income Taxes
C3-59
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
Individual Income Taxes
C3-60
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
Individual Income Taxes
C3-61
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
Individual Income Taxes
C3-62
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
Individual Income Taxes
C3-63
Max Tax Rates for Net
Capital Gains of Individuals
Classification
Maximum Rate
Short-term gains (held ≤ one year)
35%
Long-term gains (held > one year)
• Collectibles
28%
• Certain depreciable property
used in a trade or business
(unrecaptured § 1250 gain)
25%
• All other long-term capital gains
15%, 5%,
or 0%
Individual Income Taxes
C3-64
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
Individual Income Taxes
C3-65
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
Individual Income Taxes
C3-66