chapter 1 the individual income tax return · tax/reporting requirements understand and apply tax...

CHAPTER 1The Individual

Income Tax Return

Income Tax Fundamentals 2011

Gerald E. WhittenburgMartha Altus-Buller

2011 Cengage Learning

1

Learning ObjectivesUnderstand history/objectives of U.S. tax lawDescribe different entities subject to

tax/reporting requirementsUnderstand and apply tax formula Identify who must file tax returns and select

filing statusCalculate number of exemptions and

exemption amountsCalculate standard/itemized deductionsCompute basic capital gains and lossesAccess and use various internet tax resources

2011 Cengage Learning 2

History of Taxation

Since 1913, when 16th

amendment was passed, the constitutionality of income tax has never been questioned by the federal courts


THE 16TH AMENDMENT OF THE UNITED STATES CONSTITUTION

“The Congress shall have power to lay and collect taxes on incomes, from whatever source derived, without apportionment among the several States, and without regard to any census or enumeration.”


What does the 16th Amendment mean?

This amendment allows the Congress to levy an income tax without apportioning it among the states or basing it on Census results. This amendment exempted income taxes from the constitutional requirements regarding direct taxes, after income taxes on rents, dividends, and interest were ruled to be direct taxes in Pollock v. Farmers' Loan & Trust Co. (1895). It was ratified on February 3, 1913.


http://en.wikipedia.org/wiki/Income_tax�

http://en.wikipedia.org/wiki/U.S._state�

http://en.wikipedia.org/wiki/United_States_Census�

http://en.wikipedia.org/wiki/Direct_tax�

http://en.wikipedia.org/wiki/Direct_tax�

http://en.wikipedia.org/wiki/Pollock_v._Farmers'_Loan_&_Trust_Co.�

Income taxes serve a multitude of purposes:

Objectives of Tax Law Raise revenue

Tool for social and economic policies◦ Social policy encourages desirable activities and discourages

undesirable activities Credits for investment in solar and wind energy

Can deduct charitable contributions

Credits for higher education expenses

◦ Economic policy as manifested by fiscal policy Encourage investment in capital assets through depreciation

◦ Both economic and social Exclude gain on sale of personal residence up to $250,000 ($500,000 if married)


Primary Entities/Forms

Individual◦ Taxable income includes wages, salary, self-

employment earnings, rent, interest and dividends◦ An individual may file simplest tax form qualified for 1040EZ 1040A 1040

◦ If error made on one of the three above forms, can amend with a 1040X


See next slide


Individual◦ 1040EZ Single or Married Filing Jointly (MFJ) Must not be 65 or older and/or blind Must not claim any dependents Taxable income must be under $100,000 Only wages, salaries or unemployment and not more

than $1,500 taxable interest income Not received advance earned income credit



Individual (continued)◦ 1040A Generally used by taxpayers who are not self-

employed and don’t itemize deductions◦ 1040 If taxpayer doesn’t qualify to use 1040EZ or

1040A,should complete a 1040 with possible schedules attached Schedule A to itemize deductions Schedule B to report dividends/interest income > $1500 Schedule C to report trade/business income Schedule D to report capital gains/losses Schedule E to report rental/royalty income Schedule F to report farm/ranch activities



Corporations◦ Tax rate schedule found on page 1-4◦ Corporations need to file 1120 or 1120S◦ 1120S are for corporations that elect S Corporation status Don’t pay regular corporate income taxes Instead, pass through items of income or loss to shareholders

Partnerships◦ Reporting entity, not taxable entity◦ 1065 – reports income/loss and allocation to partners Pass through items of income or loss to partners


Tax Formula for Individuals

This formula follows Form 1040

Gross Income

less: Deductions for Adjusted Gross Income (AGI)AGI

less: Greater of Itemized or Standard Deductionless: Exemption(s)

Taxable Incometimes: Tax Rate (using tax tables or rate schedules)

Gross Tax Liability less: Tax Credits and Prepayments

Tax Due or Refund


Standard Deduction & Exemptions


2010 standard deduction ($)Single 5,700Married Filing Joint (MFJ) 11,400Qualifying Widow(er) 11,400

also known as Surviving Spouse (SS)Head of Household (HOH) 8,400Married Filing Separate (MFS) 5,700

*Taxpayers 65 or older and/or blind get an additional amount$1,100 if MFJ, MFS or SS$1,400 if HOH or Single

2010 exemption $3,650 – personal & dependency

Using Tax Formula


Facts: Juan (age 29) is a single taxpayer. In 2010, 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:

Gross income ___________

Deductions for AGI ___________

Adjusted gross income ___________

Greater of the standarddeduction or itemized deductions ___________

Exemptions ___________

Taxable income ___________

Solution


Gross income $40,000

Adjusted gross income ___________




Gross income = $39,000 + 1,000

Solution



Adjusted gross income 37,500




AGI = $40,000 – 2,500

Solution




Greater of the standarddeduction or itemized deductions 5,700

Exemptions


The standard deduction of $5,700 exceeds itemized deductions of $3,000

Solution




Greater of the standarddeduction or itemized deductions 5,700

Exemptions 3,650

Taxable income $28,150

Who Must File Based on filing status and gross income◦ Generally, if exemptions

plus

greater of standard or itemized deductions exceed income, then filing is not necessary

◦ If taxpayer is claimed as a dependent on another taxpayer’s return, dependent’s standard deduction is: Greater of $950

or Earned income + $300 But never more than standard deduction

See Figures 1.1 and 1.2 on page 1-8


Who Must File

Taxpayer must file if◦ Owe any special taxes See Figure 1.3 on page 1-9◦ Received Advanced Earned Income

Credit payments from employer◦ Had self-employment income >= $400◦ Other special situations as outlined on

Chart C (Figure 1.3)


Which Taxpayers are Required to File

Note: Must analyze each independent situation to determine if the taxpayer is required to file a return for 2010

Miles (age 45) is a single waiter and has unreported tips of $1,510; is he required to file?

Yes, because Miles owes social security taxes on unreported tips.



Simone is single (age 31) and blind and has income of $9,950; is she required to file?

No, because standard deduction = $7,100 ($5,700 + 1,400); exemption= $3,650. These amounts total to $10,750 and exceed her gross income.



Eamon (age 67) and his wife, Roisin, (age 69) have income of $19,180 and file jointly; are they required to file?

No, because standard deduction = $13,700 ($11,400 + 1,100 + 1,100); exemptions = $7,300. These amounts total to $20,900 and exceed their gross income.



Taig 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 he required to file?

Yes, because standard deduction = $5,700 and his income exceeds this amount. His exemption is 0 as he’s claimed by parents.


Filing Status Single ◦ Unmarried or legally separated as of 12/31

◦ And not qualified as married filing separately, head of household or qualifying widow(er)

Married Filing Jointly (MFJ) ◦ If married on 12/31 – even if didn’t live together entire year

◦ Same-sex couples may not file jointly

◦ If spouse dies during year you can file MFJ in current year

Married Filing Separately (MFS)◦ Each file separate returns

◦ Must compute taxes the same way - both itemize or both use standard

◦ If living in community property state, must follow state law to determine community and separate income


Filing Status Head of Household (HOH) ◦ Tables have lower rates than single or MFS

◦ Taxpayer can file as HOH if: Unmarried or abandoned* as of 12/31 Paid > 50% of cost of keeping up home that was

principal residence of dependent child or other qualifying dependent relative There is one exception to principal residence requirement.

If dependent is taxpayer’s parent, he/she doesn’t have to live with taxpayer.

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


*See pages 1-10 and 1-11 for requirement for abandoned spouse

Filing Status

Qualifying Widow(er) with Dependent Child◦ Also known as surviving spouse◦ Available for two subsequent years after

death of spouse Must pay over half the cost of maintaining a

household where a dependent child, stepchild, adopted child or foster child lives

◦ Gets benefits of married filing joint tax rates


Tax Computation

Six brackets (in Appendix)◦ 10%, 15%, 25%, 28%, 33%, 35%◦ Tax rate schedules for different filing types

Qualifying dividends and net long-term capital gains may be taxed at lower rates◦ Rates based on ordinary tax bracket


Tax year 2010 laws are covered in this text. After 2010 many of the tax laws and rate structures passed 2001-2009 will “sunset”. The new tax rate structure will depend upon what Congress enacts.

Making Work Pay Credit

This is a refundable credit amounting to $400 ($800 MFJ)

o Phases-out when AGI exceeds $75,000 ($150,000 MFJ)

o Complete Schedule M to calculate credito Available to both employees and self-employed

taxpayers


Personal/Dependency Exemptions

Personal exemptions may be taken for self and spouse

Additional exemptions may be taken for individuals who are either taxpayer’s◦ Qualifying child

or◦ Qualifying relative

For 2010 each exemption = $3,650

In years prior to 2010, exemptions phased-out for high-income taxpayers. It is anticipated that the phase-out

will be reintroduced in 2011


Dependency – Qualifying Child

Dependency exemption allowed when six tests metRelationship 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.

Domicile Test- child has same principal place of abode as taxpayer for more than ½ the year.

Age Test – child is under 19 or a full-time student under 24 (enrolled at least 5 months of year).


Dependency – Qualifying Child

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).

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.

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.


What if Child MeetsDependency Requirements for More

than One Taxpayer?If one of the parties is a parent, he/she

can claimIf both parties are a parent, then one with

whom the child resides longest can claimo If not ascertainable, parent with highest AGI

may claim

If no parents are involved, person with highest AGI may claim


Dependency – Qualifying Relative

Dependency exemption may be granted for a qualifying relative (who is not a qualifying child) based on tests on next slide.

Note: A taxpayer’s child who does not meet qualifying child test may meet qualifying relative test!!


Dependency – Qualifying Relative

Relationship or Member of Household Test – list of relatives that qualify is available at IRS web site

Note: A member of household (even if unrelated) for entire year meets the relationship test

Gross Income Test – individual may not have gross income in excess of $3,650

Support Test – dependent must receive over ½ of his/her support from taxpayer

Joint Return Test – dependent may not file a joint return unless it’s solely to claim refund

Citizenship Test – dependent must meet the citizenship test identified in the qualifying child slide


Standard Deduction


2010 standard deductionSingle $ 5,700Married Filing Joint (MFJ) $11,400Qualifying Widow(er) $11,400

also known as Surviving SpouseHead of Household (HOH) $ 8,400Married Filing Separate (MFS) $ 5,700

*Plus additional amounts for blindness or over 65: $1,100 if MFJ, MFS or qualifying widow(er) and $1,400 if HOH or Single

For 2008-2009 (and likely extended to 2010), taxpayer may add lesser of $500 (or $1,000 MFJ) or actual real estate

taxes paid to standard deduction amount.

Standard Deduction - Dependents


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 parentsclaim her as a dependent; she earned $2,000 in 2010, how much is taxable income?

$2,000 earned income(2,000) standard deduction

$0 taxable income

Example 2: Tia is 18 - has dividend income of $1,500 (dividends are considered unearned income), how much is taxable income?

$1,500 dividend income( 950) standard deduction$ 550 taxable income

Basic Gain & Loss Model


Amount Realized*

- Adjusted Basis**

Realized Gain/Loss* Sales Price - Sales Expenses

** Cost - Accumulated Depreciation

Note: Most realized gains/losses are also recognized (i.e. – included in taxpayer’s income)

Capital Gains/Losses

A capital asset is any property (personal or investment) held by a taxpayer, with certain exceptions as listed in the tax law ◦ Examples: stocks, bonds, land, cars and other

items held for investment◦ Gains/losses on these assets are subject to

special rates Holding period of asset determines

treatment ◦ Long-term is held >12 months (taxed at capital

rates – see next screen)◦ Short-term is held <= 12 months (taxed at ordinary

rates)2011 Cengage Learning 39

Capital Gains/Losses

Long term capital gain ◦ Special rates depending upon taxpayer’s bracket

Ordinary Tax Bracket Capital Gains Tax Rate10% or 15% 0%

All other brackets 15%

Long term capital loss ◦ Only allowed $3,000 net capital loss per year against

ordinary income

◦ Carry-forward any unused balance


Calculating Gain/Loss


Facts: Noah purchased Sony AAA bonds in 2006 for $47,600. In 2010, 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 ___________

Solution


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

Tax and The Internet


Volumes of tax information available on internet

• http://www.irs.gov contains forms and publications and a search engine to aid the user in obtaining useful information

• www.ftb.ca.gov is the California Franchise Tax Board’s site and contains pertinent information for preparing California taxes

The IRS has also launched a YouTube video site and an iTunes podcast site

In some states, names of delinquent taxpayers posted on web sites

http://www.irs.gov/�

http://www.ftb.ca.gov/�

The End!(of Chapter 1!)


chapter 1 the individual income tax return · tax/reporting requirements understand and apply tax...

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