Chapter
14
The Individual Tax Model
Filing Status - Married
If married on the last day of the year: status must
be either Married filing joint or Married filing
separately.
MFJ rates apply to Surviving Spouse
widow or widower with a dependent child for two more
years after death of spouse.
MFS (married filing separately) rates are less
favorable than single.
Generally only used for separated couples or US citizens
or residents married to a nonresident alien
Filing Status - Unmarried
Single is the default category for unmarried
individuals (neither surviving spouse nor head of
household).
Head of household - maintain a home for either
child (need not be dependent)
dependent relative
Taxable Income Computation
 Calculate total income totaling Line 22 on
1040.
 Calculate Adjusted Gross Income (AGI) on
Line 37 of 1040.
 Subtract the greater of:
itemized deductions or
 the standard deduction
Subtract total exemptions
Result is Taxable Income
Individual Tax Model – Gross Income / Exclusions
General Rule: Gross Income is “Broadly Conceived”: Includes all income
subject to taxation unless specifically indicated as not taxable by law.
Exclusions include:
 unrealized gains, gifts, inheritances, welfare type payments, many fringe
benefits, returns of capital, Municipal Interest, some US Govt for higher
education, life insurance proceeds.
Scholarships - excludible if
recipient is candidate for degree, amount received is not a payment
for services, and is used to pay tuition, books, and other similar
educational expenses
Foreign earned Income (Sec. 911) - build U.S. Economy
Exclude up to $100,800 of foreign earned income annually plus a
housing allowance (exclusion cannot exceed earned income
Individual must be a bona fide resident of the foreign country for an
entire tax year or be in the foreign country for 11 mos in any 12 month
period.
Individual Tax Model: Special Income Inclusions
Annuities: Amount not taxed: Inv. / Expected Return *
Pymts Rec
Deferred Compensation Plans: Defined Contribution
Plans, Defined Benefit Plans - Qualified Retirement Plans
Prizes and Awards - include FMV
Social Security Benefits - up 85% may be taxed
Unemployment compensation is taxable
Alimony received is taxable / Child support is not
includible but is not deductible either.
Special Rules
Dividends (cash and noncash) - FMV of prop
received (subject to E& P provisions)
Stock dividends generally not taxable
Damages - personal (special rules) business
damages not excludible.
Discharge of indebtedness - generally includible.
Business versus Investment
Business activity
Time and talent on regular basis
Profit partially attributable to personal involvement
Income is considered earned income
Hobby losses only deductible to extent of hobby income –
not a business activity
Investment activity
Passive role as owner of income-producing property
Income is considered unearned income
Losses on personal use assets are not deductible – gains
from sale are treated as capital assets.
Investments in Financial Assets
Securities include:
common and preferred stock
savings accounts, CDs, notes, bonds
Return on / Income from investment includes
Interest (ordinary income)
Dividends (special rules post May 2003)
Reinvested dividends are still taxable but increase basis.
gains (losses).
Mutual funds may report ‘distributed’ capital gains/losses.
These are still taxable but increase basis even if no cash
received.
Gains/Losses on Securities
Realization requires a sale or exchange
Gain/loss = Proceeds - adjusted basis
Character is capital - time period matters
Basis issues
reinvested dividends increase basis.
Sale of stock uses either specific ID or FIFO method of
matching basis with sales.
Mutual fund shares sold typically use an average basis.
What to do with Capital Gains and Losses
SHORT TERM asset held for <= 1 year – gains taxed as
ordinary income
LONG TERM asset held for > 1 year
L/T Gains taxed at lower capital gains tax rate of 20%
Net the gains and losses in each class (net ST, net LT, net
28%LT).
Special rule for sale of principal residence
Exclude gain up to the amount of statutory exclusion if home is
principal residence 2 years out of 5 years ending on date of sale.
Exclude only one gain every 2 years.
Limits $500,000 MFJ, $250,000 other
Deductions for Adjusted Gross Income and AGI
Deductions for Adjusted Gross Income
 Trade/Business Exp from a Sole Proprietorship are reported on Schedule C /
or for a rental property are recorded on schedule E
 Student Loan interest up to $2500 (Income limits apply)
 Self Employed Expenses: 50% of SE tax, percentage of health insurance
premiums, Keogh and Simple retirement plans
 IRAs, Moving Expenses, Contributions to MSAs
 Penalty for early withdrawal of savings
Result of Income less deductions for Adjusted Gross
Income –is AGI (very key concept) - many deductions are a
function of AGI (e.g., IRA deductions, medical expenses,
charitable contributions)
Many items of gross income are also a function of AGI
Social Security Benefits, Passive Activity Losses
Deductions from AGI: Standard Deduction or
Itemized Deductions
Standard Deduction Depends on filing status. For
2014/15:
MFJ = $12,400/$12,600
MFS = $6,200/$6,300
HOH = $9,100 / $9,250
Single = $6,200/$6,300
Blind or aged (>=age 65)
MJF, MFS = additional $1,200/$1,250
HOH or Single = additional $1,550
Take the higher of Standard Deduction or Itemized
Deductions as a reduction of AGI in the computation of
Taxable Income – Discussion of Itemized Deductions follows
Itemized Deductions / Personal Losses - Chapter 17
Itemized deductions
a special class of deductions that allow taxpayers to derive tax
benefits from certain personal & investment expenditures
Individuals deduct the greater of the standard deduction for
his/her filing status or the total of his/her itemized
deductions.
About 1/3 of all TPs claim itemized deductions
Itemized deductions are shown on Form 1040 Schedule A.
Medical Expense Deduction
Sec. 213 - qualified non-reimbursed medical expenses for a TP and
dependents qualify for a deduction subject to a 10% of AGI floor (7.5% if
over 65) - only 5% of TPs benefit
Qualifying expenses include
Medical insurance premiums / prescription drugs
Medical treatment / Physical & Psychological treatment
medical products, glasses, artificial limbs etc.
Capital improvements - limited to excess over increase in home value
due to the improvements.
Capital improvements to remove structural barriers for physically
handicapped - fully deductible.
Cosmetic surgery if it results from disease, personal injury or
congenital defects.
No deduction allowed for:
Elective cosmetic surgery
Taxes
Sec 164 - lists deductible taxes
In general - only income taxes (other than Federal) and property taxes ad valorem taxes on investment and personal property are deductible.
Taxes must be distinguished from assessments, fines & penalties which
are not deductible.
Taxes are only deductible when they are the taxpayers obligations. No
deduction for paying another persons taxes. No deduction is someone
else pays your taxes.
50% of SE tax is deductible,
Sales tax are deductible if total is greater than income taxes paid to a
particular state.
Interest
 Sec 163 - certain types of interest paid or accrued by a taxpayer during
the year is deductible
 Mortgage interest, some points, home equity interest or investment
interest - are individual itemized deductions
 Investment interest expense- deductible to extent of net investment
income ( Gross Inv. Inc - Inv. Exp.)
 Inv. Interest deduction not allowed if used to purchase tax exempt
securities.
 Qualified Residence Interest
 indebtedness used to purchase, construct or improve the taxpayers
residence
 2 homes allowed -Int on debt up to $1 Million is ded..
 Home equity interest limited to principal of 100K
 Point on new loan or improvement loan deductible when paid.
Refinancing - amortized over loan life.
Charitable Contributions
 Sec 170 - gifts to qualified charities is deductible
 Qualified charities: U.S. based organizations operated exclusively for religious,
charitable, scientific, literary or educational purposes or for the prevention of
cruelty to children or animals.
 Contribution amount
 reduced by value of any benefit received by the donor
 LTCG property = value is FMV
 No deduction allowed for contribution of services or rent free use of property.
 Contribution Limits
 LTCG property - limited to 30% of AGI
 Total contributions limited to 50% of AGI
 Excess contributions can be carried forward 5 years
 If contributing property, TP must be able to substantiate value.
 Must file form 8283 if noncash contributions > 500
 Independent appraisal is required when a single item of donated property is valued in
excess of $5,000.
Casualty Losses / Miscellaneous Itemized Deductions
 Casualty losses - unreimbursed losses due to theft or casualty. Losses
are reduced by $100 and 10% of AGI. Excess, if any is deductible as
an itemized deduction.
 Misc. deductions subject to 2% of AGI limitation- (must exceed 2% of
AGI to be deductible)
 Unreimbursed Employee Business Expenses - union dues,
uniforms, business use of auto, job search, other prof. Dues
 Expenses for managing or safeguarding assets: safe deposit rental,
investment advice, investment publications
 Tax determination expenses: Tax prep fees, legal representation in
tax audit, legal and accounting fees for tax planning, appraisals for
tax reporting
 Misc. deductions not subject to 2% limitation
 gambling losses to extent of gambling winnings
 unrecovered investments in annuities due to annuitants death.
Exemptions
Personal exemption for the taxpayer (2 for MFJ).
If you are a dependent on someone else’s return, can you
still claim yourself?
Exemption = $3,950/$4,000 in 2014/15 for each
personal or dependency exemption.
Exemptions for Dependents
Family member OR live in your home for entire
year.
You provide > 1/2 financial support
Dependent’s gross income < exemption amount
($3,950 for 14)
waived for child < 19 OR student-child<24
Dependent may not generally file a joint return.
Dependent must be a U.S. citizen OR a resident of
US, Mex, Canada
Rich People
Phase-out of itemized deductions – Repealed in 2010 – returned
effective for 2013 – Haircut (reduction in allowed itemized
deductions) = AGI – Threshold ($305,050/ $309/900 (2014/15)
for MFJ) * 3%.
Phase-out of exemptions – Repealed in 2010. Returned effective
1/1/2013. For our class assume if AGI is greater than $435,000
then no personal exemptions are allowed. If AGI < $435,000
allow full amount of exemptions.
Tax on net investment income (dividends, interest, capital gains,
net income on passive activities): 3.8% for individuals with
income in excess of $200,000, MFJ in excess of $250,000 .
Please know it exists but we will not compute the tax on our
assignments for this course.
Tax Credits
A credit is a dollar for dollar reduction in the tax liability. A
deduction only reduces the tax by the marginal tax rate
associated with that deduction.
Child Credit = $1,000 per child in 2014 Phases out for rich.
Dependent care credit (child < 13 years old). Credit amount
between 30% and 20% of child care costs depending on
income range.
Earned income credit. This is refundable - a transfer
payment to working poor. Increases progressivity of tax
rates. Credit is higher for taxpayers with children and phases
out as income increases.
Excess FICA withholding is refunded through a tax return
claim.
Tax Subsidies for Education
Hope scholarship credit / American job opportunity
cred - 1st 4 years of college. Max $2500 per year
per student based on tuition/fees. Phase out for
MFJ between $160-180K)
Lifetime learning credit = 20% of tuition/fees: Max
$5000 per year. Lifetime credit phase out begins
$110- 130K for MFJ
Education IRA - withdrawals spend on education
are tax-free.
Payment and Filing Requirements
Taxes on wages are withheld each pay
period.
Estimated taxes are due on April 15, June
15, September 15, and January 15.
Pay 90% of current year tax, 100% of prior
year (or 110% of prior year AGI>$150,000).
Tax return due 4/15, but may be extended to
10/15 (LAST DATE).
Kiddie Tax
Children under age 18 with unearned income greater than
$2,000 are subject to kiddie tax
The unearned income in excess of $2,000 is taxed at the
parent’s highest marginal tax rate
The residual taxable income is taxed at the child’s rate.
What are the kiddie tax provisions designed to prevent?
Wealth Transfer Tax System – Covered on last
day of class.
This is an excise tax system which is
different from the income tax system.
Gift, estate, and generation skipping transfer
taxes
The unified gift and estate tax is based on
cumulative transfers over time (life + death).
Current tax rate is 35%
Gift Tax
Remember, all receipts of gifts are excluded
from INCOME taxation. We are now
discussing GIFT taxation.
Exclude $14,000 per year per donee from
taxable gifts.
No gift tax on gifts to spouse, charity, paying
tuition or medical costs.
Can treat gift by one spouse as made 1/2 by
other spouse.
Exclusion
Lifetime exclusion
$5,340,000
Income Tax Effects of Gifts
Gift is not taxable income to donee.
Donor’s adjusted basis in the property
carries over to become the donor’s basis.
exception - use FMV if less than adjusted basis
After gift, any income derived from the
property belongs to the donee.
Estate Tax
Taxed at unified estate and gift rate
schedule
FMV of estate is taxed
Unlimited marital deduction
Reduce estate by taxes, charity,
administrative expenses.
Income Tax Effect of Bequests
Receipt of a bequest is not taxable income
to heir.
Basis = FMV at date of death = free income
tax step-up in basis. (In 2010, wealthy
estates generate carryover basis).
Trade-off gift now at low basis, perhaps avoid some transfer tax
keep and include in estate, but heirs get high basis