CH.4 Individual Income Tax Overview, Dependents, and Filing Status
Qualifying widow or widower
-Available for the two years following the year of spouse's death -Surviving spouse does not qualify if remarries during two-year period. -Surviving spouse must maintain household for dependent child.
Dependency requirements
-Citizen of U.S. or resident of U.S., Canada, or Mexico -Must not file joint return with spouse Exception - if no tax liability filing jointly or separately -Must be qualifying child or qualifying relative of taxpayer
Determining who qualifies as dependent is relevant for determining:
-Filing status -Eligibility for tax benefits such as the child tax credit and the American opportunity credit
The Individual Income Tax Formula
Taxable income Times: Tax rates ---------------------- Equals: Income tax liability Plus: Other taxes ----------------------- Equals: Total tax Minus: Credits Minus: Prepayments ------------------------ Equals: Taxes due or (refund)
Individuals report taxable income to the IRS. Reported on Form 1040
U.S. tax laws use all-inclusive income concept. Realized income -Measurable change in property rights -All realized income included in gross income unless specifically excluded or deferred Recognized income -Reported on tax return
Single
Unmarried unless qualify for head of household
2018 standard deduction amounts
$24,000 Married filing jointly $24,000 Qualifying widow or widower $12,000 Married filing separately $18,000 Head of household $12,000 Single Additional standard deduction amounts for age and eyesight (discuss in Individuals Deductions chapter)
Other taxes include:
+Alternative minimum tax +Self-employment taxes +3.8% net investment income tax +.9% additional Medicare tax +Tax credits Reduce tax liability dollar for dollar
Deductions from AGI
+Deducted from adjusted gross income to determine taxable income +"Deductions below the line" +Deduction for qualified business income (not an itemized deduction) +Deduction = Qualified business income × 20% Greater of standard deduction or itemized deductions +Common itemized deductions Mortgage interest State income taxes Charitable contributions
Relationship Test (Qualifying Relative)
-A descendant or ancestor of the taxpayer (e.g., child, grandchild, parent, or grandparent), -A sibling of the taxpayer including a stepbrother or stepsister -A son or daughter of the taxpayer's brother or sister -A sibling of the taxpayer's mother or father An in-law (mother-in-law, father-in-law, sister-in-law, or brother-in-law) of the taxpayer, or -An unrelated person who lives in taxpayer's home entire year
Deductions for AGI
"Deductions above the line" +Deducted in determining adjusted gross income +Always reduce taxable income dollar for dollar +Common for AGI deductions -Alimony paid (pre 2019 divorce decree) -Rental and royalty expenses -Contributions to qualified retirement accounts
Married individuals treated as unmarried (abandoned spouse) if individual
-Is married at end of year (or is not legally separated from the other spouse) -Does not file a joint tax return with the other spouse -Pays > ½ the cost of maintaining a household that serves as principal abode for a qualifying child for more than half the year -Lived apart from the other spouse for the last six months of the year (other than temporary absences)
Married filing jointly
-Must be married on the last day of the year -If one spouse dies, the surviving spouse is considered to be married to decedent spouse at year end. Exception - The surviving spouse remarries before year's end
tie breaking rules (qualifying child)
-Parents first -Days living with each parent if parents living apart -AGI - higher AGI gets exemption
Qualifying person (head of household)
-Qualifying child -Qualifying relative who is taxpayer's mother or father Parent need not live with taxpayer Taxpayer must pay > ½ cost of maintaining separate household for taxpayer's mother or father Parent must qualify as taxpayer's dependent -Qualifying relative who is not the taxpayer's parent Person must have lived with taxpayer for more than half the year Must qualify as taxpayer's dependent Must be related to taxpayer through qualified family relationship If related only because lived with taxpayer for entire year, not a qualified person
Qualifying Child
-Relationship test -Age test -Residence test -Support test
Qualifying Relative Tests
-Relationship test -Support test -Gross income test
Support Test (Qualifying Relative)
-Taxpayer must pay > ½ of living expenses (support) -Scholarships of actual child excluded
Married filing separately
-Taxpayers are married but file separate returns. -Typically not beneficial from tax perspective -Tax rates and other tax benefits -May be beneficial for non-tax reasons -No joint and several liability
Head of household
-Unmarried -Pay more than half the cost to keep up a home -Have a qualified person living with you more than half of the year
What is the difference between a tax deduction and a tax credit? Is one more beneficial than the other? Explain.
A deduction generally reduces taxable income dollar for dollar (although from AGI deductions may not reduce taxable income dollar for dollar). This translates into a tax savings in the amount of the deduction times the marginal tax rate. In contrast, credits reduce a taxpayer's taxes payable dollar for dollar. Thus, generally speaking, credits are more valuable than deductions.
support test (qualifying child)
Child must not provide more than half of his or her own support. Scholarships of actual child (not grandchild, for example) are excluded from support computation
Character of income or loss
Determines rates applicable to income or loss in current year -Tax exempt - no tax -Tax deferred - no tax in current year (current year tax rate is zero) -Ordinary - ordinary rates from tax rate schedule -Qualified dividends taxed at 0%, 15%, or 20% depending on taxpayer's income level.
Excluded and deferred income not included in gross income.
Excluded income -Municipal bond interest -Gain on sale of personal residence Deferred income -Income included in a subsequent tax year -Installment sales -Like-kind exchanges
Capital assets
Generally all assets except -Accounts receivable -Inventory -Assets used in trade or business, including supplies
Individual Income Tax Overview, Dependents, and Filing Status
Gross income Minus: For AGI deductions ----------------------------- Equals: Adjusted gross income Minus: From AGI deductions: Greater of (a) Standard deduction or (b) Itemized deductions Deduction for qualified business income ----------------------------------------- Equals: Taxable income
Gross Income Test (Qualifying Relative)
Gross income < $4,150 in 2018
Assume Shawn (Rodney's brother) lived with the Halls, but Shawn paid more than half the costs of maintaining a separate apartment that is the principal residence of his mother, Sharon, whose gross income is $1,500. Because Shawn provided more than half of Sharon's support during the year, and because Sharon's gross income was only $1,500, she qualifies as Shawn's dependent (as a qualifying relative). In these circumstances, what is Shawn's filing status?
Head of household. Shawn paid more than half the costs of maintaining a separate household that is the principal place of abode for his mother, and his mother qualifies as his dependent.
Are taxpayers allowed to deduct net capital losses (capital losses in excess of capital gains)? Explain.
In general, a taxpayer is allowed to deduct, as a "for AGI deduction," up to $3,000 of net capital loss against ordinary income. If the net capital loss exceeds $3,000, the taxpayer is allowed to carry the loss over indefinitely to deduct in subsequent years (subject to the $3,000 annual deduction limitation). If however, a capital loss arises from the sale of a personal use asset (such as a personal automobile or a personal residence), the loss is not deductible.
Five different filing statuses:
Married filing jointly Married filing separately Qualifying widow or widower (surviving spouse) Single Head of household
Capital gains and losses
Net long-term capital gains in excess of net short-term capital losses are generally taxed at 0%, 15%, or 20% depending on the taxpayer's taxable income. -Short-term capital gains taxed at ordinary rates. -Net capital losses (losses in excess of gains for year) $3,000 deductible against ordinary income for year Losses in excess of $3,000 carried forward
Tax prepayments
Payments already made toward tax liability including: -Income taxes withheld from wages by employer -Estimated tax payments made during the year -Taxes overpaid in prior year and applied toward current year's liability **If prepayments exceed tax liability after credits, taxpayer receives a refund.
Assume that last year Rodney passed away, and during the current year Anita did not remarry but maintained a household for Braxton and Tara, her dependent children. Under these circumstances, what would Anita's filing status be?
Qualifying widow
residence test (qualifying child)
Same residence as taxpayer for more than half the year -Exception for temporary absences such as education
In each of the following independent situations, determine the taxpayer's filing status and the number of dependents the taxpayer is allowed to claim. a. Frank is single and supports his 17-year-old brother, Bill. Bill earned $3,000 and did not live with Frank.
Single with one dependent (Bill).
How do taxpayers determine whether they should deduct their itemized deductions or utilize the standard deduction?
Taxpayers generally deduct the greater of (1) the applicable standard deduction or (2) their total itemized deductions, after limitations. However, taxpayers that do not want to bother with tracking itemized deductions may choose to deduct the standard deduction, even when itemized deductions may exceed the standard deduction. However, under the new law created by the Tax Cuts and Jobs Act (TCJA), the standard deduction was significantly increased and several itemized deductions were eliminated or limited. Consequently, even more taxpayers will be claiming the standard deduction rather that deducting itemized deductions.
Tax calculation
The U.S. uses a progressive tax rate schedule. New rate schedule for 2018 Some items are taxed at preferential rates. -Long-term capital gains -Qualified dividends -Tax on these items is calculated separately from income taxed at ordinary rates.
Why are some deductions called "above the line" deductions and others called "below the line" deductions? What is the "line"?
The line is adjusted gross income (AGI). AGI is considered the line because of the significance it plays in the amount of deductions allowed from AGI. "For AGI" deductions are called above-the-line deductions because they are deducted in determining AGI. "From AGI" deductions are called below-the-line deductions because they are deducted after AGI has been determined. They are deducted from AGI to arrive at taxable income. Below the line deductions may be subject to limitations based on the taxpayer's AGI.
In general terms, what are the differences in the rules for determining who is a qualifying child and who qualifies as a dependent as a qualifying relative? Is it possible for someone to be a qualifying child and a qualifying relative of the same taxpayer? Why or why not?
The rules for determining who qualifies as a dependent as a qualifying child and who qualifies as a dependent as a qualifying relative overlap to some extent. The primary differences between the two are: (1) the relationship requirement is more inclusive for qualifying relatives than qualifying children, (2) qualifying children are subject to age restrictions while qualifying relatives are not, (3) qualifying relatives are subject to a gross income restriction while qualifying children are not. (4) taxpayers need not provide more than half a qualifying child's support, though the child cannot provide more than half of his/her own support, but, absent a multiple support agreement, taxpayers must provide more than half the support of a qualifying relative, and. (5) qualifying children are subject to a residence test (they must live with the taxpayer for more than half the year) while qualifying relatives are not. An individual may not be a qualifying child and a qualifying relative of the same taxpayer. By definition, a qualifying relative must be someone who is not a qualifying child. Consequently, the qualifying relative tests apply only when the individual does not pass the qualifying child tests.
Gary and Lakesha were married on December 31 last year. They are now preparing their taxes for the April 15 deadline and are unsure of their filing status. a. What filing status options do Gary and Lakesha have for last year?
To be married for filing status purposes, taxpayers must be married at the end of the year. Although Gary and Lakesha were married on the last day of the year, they are still considered married for the entire year for filing purposes. Gary and Lakesha may file as married filing jointly, or they may elect to file as married filing separately.
Age test (qualifying child)
child must be younger than the individual claiming the child as a qualifying child and either: Under age 19 at the end of the year, Under age 24 at the end of the year and a full-time student, or Permanently and totally disabled.
Capital gain or loss -
depends on whether short-term or long-term -From selling capital asset -If held capital asset more than a year gain or loss is long-term, otherwise it is short-term -Net long-term gains taxed at preferential rates.
Assume Rodney and Anita divorced last year. During the current year, Braxton lives with Anita and Anita pays all the costs of maintaining the household for herself and Braxton. Under these circumstances, what is Anita's filing status for the current year?
head of household
Relationship test (qualifying child)
taxpayer's son, daughter, stepchild, an eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister or a descendant of any of these relatives.