CH3: Computing the Tax

The following individual taxpayers cannot use the standard deduction and therefore must itemize their deductions.

-A married individual filing a separate return where either spouse itemizes deductions. -A nonresident alien (i.e., an individual who is neither a U.S. citizen nor a U.S. resident).

For 2020, a dependent must file a return for the year if he or she has any of the following.

-Earned income only and gross income that is more than the total standard deduction (including any additional standard deduction). -Unearned income only and gross income of more than $1,100 plus any additional standard deduction. -Both earned and unearned income and gross income of more than the larger of $1,100 or the sum of earned income plus $350 (but limited to the basic standard deduction), plus any additional standard deduction.

A parent may elect to report the child's unearned income that exceeds $2,200 (the same in 2019) on the parent's own tax return if the child meets all of the following requirements:

-Gross income is from interest and dividends only. -Gross income is more than $1,100 but less than $11,000 (for 2019, these amounts are the same). -No estimated tax has been paid in the name and Social Security number of the child, and the child is not subject to backup withholding.

The term qualifying child is used in several Code provisions, including those relating to:

-Head-of-household filing status. -Credit for child and dependent care expenses. -Earned income tax credit. -Child tax credit.

Expenses of some expenses that are NOT deductible

-Personal living expenses. -Losses on the sale of personal use property. -Hobby expenses. -Life insurance premiums. -Gambling losses (in excess of winnings). -Child support payments. -Fines and penalties. -Political contributions. -Unreimbursed employee business expenses. -Capital expenditures.

A Qualifying Child Must Meet the:

-Relationship Test -Residence Test -Age Test -Support Test

There are five filing statuses, and all taxpayers will file a return based on the filing status selected.

-Single. -Married, filing jointly. -Married, filing separately. -Surviving spouse (qualifying widow or widower). -Head of household.

The taxpayer's filing status is used to determine:

-The taxpayer's standard deduction (see Exhibits 3.4 and 3.5). -Whether the taxpayer must file a tax return. -The taxpayer's tax liability. -Reductions of itemized deductions and certain tax credits. -Eligibility for certain provisions (e.g., some credits are not available when the married, filing separately status is used).

The allowed tax credit can be determined using the following steps.

1-AGI-Threshold = Excess Amount 2-Excess amount / $1,000 = Reduction factor (round up to next whole number;for example, 18.2=19) 3-Reduction factor x $50 = Child and dependent tax credit reduction. 4-Maximum child and dependent tax credit amount - Child and dependent tax credit reduction = Child and dependent tax credit allowed.

Income

"Income" is thought of in very broad terms; it includes all of the taxpayer's income, both taxable and nontaxable. The courts define "income" as any increase in wealth. Income under the tax rules does not include a return of capital or the receipt of borrowed funds.

Qualifying Child Support Test

A qualifying child cannot be self-supporting (i.e., provide more than half of his or her own support).

Qualifying Child Residence Test

A qualifying child must live with the taxpayer for more than half of the year.

Qualifying Relative Gross Income Test

A qualifying relative's gross income must be less than the exemption amount—$4,300 for 2020 and $4,200 for 2019. Gross income is the amount that the tax law counts as taxable.

Collectibles

A special type of capital asset, the gain from which is taxed at a maximum rate of 28 percent if the holding period is more than one year. Examples include art, rugs, antiques, gems, metals, stamps, some coins and bullion, and alcoholic beverages held for investment.

Tax Table

A table that is provided for taxpayers with less than $100,000 of taxable income. Separate columns are provided for single taxpayers, married taxpayers filing jointly, heads of households, and married taxpayers filing separately. § 3.

Child Tax Credit

A tax credit based solely on the number of qualifying children under age 17. The maximum credit available is $2,000 per qualifying child. (In addition, a $500 nonrefundable credit is available for qualifying dependents other than qualifying children.) A qualifying child must be claimed as a dependent on a parent's tax return and have a Social Security number to qualify for the credit. Taxpayers who qualify for the child tax credit may also qualify for a supplemental credit. The supplemental credit is treated as a component of the earned income credit and is therefore refundable. The credit is phased out for higher-income taxpayers. § 24. See also dependent tax credit.

Additional Standard Deduction

A taxpayer who is age 65 or over or blind qualifies for an additional standard deduction of $1,300 or $1,650, depending on filing status. Two additional standard deductions are allowed for a taxpayer who is age 65 or over and blind. The additional standard deduction provisions also apply for a qualifying spouse who is age 65 or over or blind, but not for a dependent.

Partial List of Exclusions from Gross Income

Accident & Health Insurance Proceeds ; Alimony received (divorce after 2018) ; 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 $50k ; Inheritances ; Interest from state and local bonds ; Life Insurance paid upon death ; Meals & lodging (if furnished for employer's convenience) ; Military allowances ; Minister's dwelling rental value or allowance ; Railroad retirement benefits (to a limited extent) ; Social Security benefits (to a limited extent) ; Veteran's benefits ; Welfare payments ; Workers' Compensation Benefits

Partial List of Gross Income Items

Alimony (divorces before 2019) ; 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 $50K) ; Hobby income ; Interest ; Jury duty fees ; Living quarters, meals (unless furnished for employer's convenience) ; Mileage allowance ; Military pay (unless combat pay) ; Partnership income ; Pension distributions ; Prizes ; Professional fees ; Punitive damages ; Rents ; Rewards ; Royalties ; Salaries ; Severance pay ; Strike and lockout benefits ; Tips and gratuities ; Travel allowance (in certain cases) ; Treasure trove (found property ; Unemployment benefits ; Wages

When property is sold or otherwise disposed of, gain or loss may result.

Amount Realized from the Sale - Adjusted basis of the property = Realized Gain (or loss)

Qualifying Child

An individual who, as to the taxpayer, satisfies the relationship, abode, and age tests. To be claimed as a dependent, such individual must also meet the citizenship and joint return tests and not be self-supporting. §§ 152(a)(1) and (c).

Qualifying Relative

An individual who, as to the taxpayer, satisfies the relationship, gross income, support, citizenship, and joint return tests. Such an individual can be claimed as a dependent of the taxpayer. §§ 152(a)(2) and (d). One who does not satisfy the qualifying child definition still may be a qualifying relative.

Head of Household

An unmarried individual who maintains a household for another and satisfies certain conditions set forth in § 2(b). This status enables the taxpayer to use a set of income tax rates that are lower than those applicable to other unmarried individuals but higher than those applicable to surviving spouses and married persons filing a joint return.

Capital assets include

Any property held by the taxpayer other than inventory, accounts receivable, and depreciable property or real estate used in a business. Thus, the sale or exchange of assets in these categories usually results in ordinary income or loss treatment.

The key point of this IRS guidance is that virtual currency is treated as property rather than as a foreign currency.

As a result, if an employee is paid in bitcoin, her wages are equal to the value of the bitcoin when received. When a holder of virtual currency uses it to acquire goods or services, the transaction is treated as a barter transaction with tax consequences to the holder.

Marital status is determined

As of the last day of the tax year, except when a spouse dies during the year. In that case, marital status is determined as of the date of death.

Qualifying Child Age Test

At the end of the tax year, a qualifying child must be under age 19 (age 24 in the case of a full-time student). A full-time student is the taxpayer's child who was in school for any part of five months of the year. An individual cannot be older than the taxpayer claiming him or her as a qualifying child (e.g., a brother cannot claim his older sister as a qualifying child). The age test does not apply to a child who is disabled during any part of the year.

Beth received the following amounts during the year. Salary $30,000 Interest on savings account 900 Gift from her aunt 10,000 Prize won in state lottery 1,000 Alimony from ex-husband (divorce finalized in 2015) 12,000 Child support from ex-husband 6,000 Damages for injury in auto accident 25,000 Ten $50 bills in an unmarked envelope found in an airport lounge (airport authorities could not locate anyone who claimed ownership) 500 Federal income tax refund for last year's tax overpayment 120 Increase in the value of stock held for investment 5,000 Determine the amount Beth must include in the computation of taxable income and the amount she may exclude.

Beth includes $44,400 in computing taxable income ($30,000 salary + $900 interest + $1,000 lottery prize + $12,000 alimony + $500 found property). She excludes $41,000 ($10,000 gift from aunt + $6,000 child support + $25,000 damages). The $120 Federal income tax refund is excluded because it represents a refund of a nondeductible expenditure made in the previous year. The unrealized gain on the stock held for investment is not included in gross income. Such gain is included in gross income only when it is realized upon a disposition of the stock.

The adjusted basis of the property is determined as follows.

Cost (or other original basis) at date of acquisition Add:Capital additions Subtract:Depreciation (if appropriate) and other capital recoveries Equals:Adjusted basis at date of sale or other disposition

Exclusions

Excluded from income tax base.

Dependent Tax Credit

For 2018 through 2025, the TCJA of 2017 replaced the dependency exemption with a $500 nonrefundable credit. This credit can be claimed for dependents who are not a qualifying child or under the age of 17. The dependent must be a citizen or resident of the United States.

Refundable Portion of Child Tax Credit

For all taxpayers with qualifying children (regardless of how many), the child tax credit is refundable to the extent of the lesser of: 1) $1,400 of the child tax credit for each qualifying child, or 2) 15 percent of the taxpayer's earned income in excess of $2,500.

Children of Divorced or Separated Parents

Generally, the parent having custody of the child (children) for the greater part of the year (i.e., the custodial parent) claims the child as a dependent. A special rule applies if the now-unmarried parents live apart for the last six months of the year and: -They would have been entitled to identify the dependent had they been married and filed a joint return. -They have custody (jointly or singly) of the child (children) for more than half of the year. The special rule allows the noncustodial parent to claim the dependent if the divorce (or separation) decree so specifies or if the custodial parent signs a waiver on Form 8332. If the special rule does not apply (i.e., the divorce decree is silent or the custodial parent does not sign Form 8332), the child (children) is a dependent under the qualifying child or qualifying relative rules.

Joint Return Test

If a dependent is married, the supporting taxpayer (e.g., the parent of a married child) generally cannot claim the individual as a dependent if the potential dependent files a joint return with his or her spouse. The joint return rule does not apply, however, if the reason for filing is to claim a refund for tax withheld.

For individual taxpayers, net capital loss can be used to offset ordinary income of up to $3,000 ($1,500 for married persons filing separate returns).

If a taxpayer reports both short- and long-term capital losses, the short-term category is used first to arrive at the $3,000. Any remaining net capital loss is carried forward indefinitely until it is used up. When carried forward, the excess capital loss retains its classification as short or long term.

Unearned Income

Income received but not yet earned. Normally, such income is taxed when received, even for accrual basis taxpayers.

Filing Status

Individual taxpayers are placed in one of five filing statuses each year (single, married filing jointly, married filing separately, surviving spouse, or head of household). Marital status and household support are key determinants. Filing status is used to determine the taxpayer's filing requirements, standard deduction, eligibility for certain deductions and credits, and tax liability.

Qualifying Relative Relationship Test

Lineal ascendants (e.g., parents and grandparents). Collateral ascendants (e.g., uncles and aunts). Certain in-laws (e.g., son-, daughter-, father-, mother-, brother-, and sister-in-law). Includes parties who live with the taxpayer for the entire tax year.

Dependent Taxpayer

Must be either a qualifying child or a qualifying relative.

Kiddie Tax

Passive income, such as interest and dividends, that is recognized by a child under age 19 (or under age 24 if a full-time student) is taxed according to the brackets applicable to the child's parent(s), generally to the extent the income exceeds $2,200 for 2020. The additional tax is assessed regardless of the source of the income or the income's underlying property. § 1(g).

Itemized Deductions from Adjusted Gross Income

Personal expenditures allowed by the Code as deductions from adjusted gross income. Examples include certain medical expenses (in excess of 7.5% of AGI), interest on home mortgages (limited to certain limitations), state income taxes, and charitable contributions (may not exceed 50% of AGI), Casualty & theft losses (in excess of 10% of AGI). Itemized deductions are reported on Schedule A of Form 1040.

Deductions for Adjusted Gross Income

The Federal income tax is not imposed upon gross income. Rather, it is imposed upon taxable income. Congressionally identified deductions for individual taxpayers are subtracted either from gross income to arrive at adjusted gross income or from adjusted gross income to arrive at the tax base, taxable income. -Expenses incurred in a trade or business. -Part of any Federal self-employment tax paid. -Certain contributions to traditional Individual Retirement Accounts (IRAs) and other retirement plans. -College tuition and related expenses. -Contributions to Health Savings Accounts (HSAs). -Interest on student loans. -Excess capital losses. -Certain alimony payments.

Gross Income

The Internal Revenue Code defines gross income broadly as "except as otherwise provided ..., all income from whatever source derived." The "except as otherwise provided" phrase refers to exclusions.

Abandoned Spouse Rules

The abandoned spouse provision enables a married taxpayer with a dependent child whose spouse did not live in the taxpayer's home during the last six months of the tax year to file as a head of household rather than as married filing separately.

Child and Dependent Tax Credits Phaseout

The available child and dependent tax credits begin to phase out when AGI reaches $400,000 for married taxpayers filing jointly ($200,000 for all other taxpayers). The credit is phased out by $50 for each $1,000 (or part thereof) of AGI above the $400,000 (or $200,000) amounts.

Standard Deduction

The individual taxpayer can either itemize deductions or take the standard deduction. The amount of the standard deduction depends on the taxpayer's filing status (single, head of household, married filing jointly, surviving spouse, or married filing separately). For 2020, the amount of the standard deduction ranges from $12,400 (for single) to $24,800 (for married, filing jointly). Additional standard deductions of either $1,300 (for married taxpayers) or $1,650 (for single taxpayers) are available if the taxpayer is blind or age 65 or over. Limitations exist on the amount of the standard deduction of a taxpayer who is another taxpayer's dependent. The standard deduction amounts are adjusted for inflation each year. § 63(c).

Qualifying Child Relationship Test

The relationship test is met by a taxpayer's child (son, daughter), adopted child, stepchild, eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of these parties (e.g., grandchild, nephew, and niece). Ancestors of any of these parties (e.g., uncle and aunt) and in-laws (e.g., son-in-law and brother-in-law) are not included.

Dependency Exemptions

The tax law provides an exemption for each individual taxpayer and an additional exemption for the taxpayer's spouse if a joint return is filed. An individual may also claim a dependency exemption for each dependent, provided certain tests are met. The TCJA of 2017 suspended the deduction for exemptions for tax years after 2017 (and through 2025).

Personal Exemptions

The tax law provides an exemption for each individual taxpayer and an additional exemption for the taxpayer's spouse if a joint return is filed. An individual may also claim a dependency exemption for each dependent, provided certain tests are met. The TCJA of 2017 suspended the deduction for exemptions for tax years after 2017 (and through 2025).

Qualifying Relative Support Test

The taxpayer must furnish more than one-half of the qualifying relative's support. Support includes food, shelter, clothing, medical and dental care, education, recreation, transportation, and similar items. If a child is being evaluated as a qualifying relative (and is a full-time student), a scholarship received by the child is not included for purposes of computing whether the taxpayer furnished more than half of the child's support. Any other relative being evaluated must include a scholarship as support in making this determination.

Citizenship Test

To be a dependent, the individual must be a U.S. citizen, a U.S. resident, or a resident of Canada or Mexico for some part of the calendar year in which the taxpayer's tax year begins.

Multiple Support Agreements

To qualify for a dependency exemption, the support test must be satisfied. This requires that over 50 percent of the support of the potential dependent be provided by the taxpayer. Where no one person provides more than 50 percent of the support, a multiple support agreement enables a taxpayer to still qualify for the dependency exemption. Any person who contributed more than 10 percent of the support is entitled to claim the exemption if each person in the group who contributed more than 10 percent files a written consent (Form 2120). Each person who is a party to the multiple support agreement must meet all of the other requirements for claiming the dependency exemption. § 152(c).

In 2020, net unearned income of a dependent child is computed as follows:

Unearned income Less: $1,100 Less: The greater of: $1,100 of the standard deduction, or The amount of allowable itemized deductions directly connected with the production of the unearned income Equals: Net unearned income

Surviving Spouse

When a husband or wife predeceases the other spouse, the survivor is known as a surviving spouse. Under certain conditions, a surviving spouse may be entitled to use the income tax rates in § 1(a) (those applicable to married persons filing a joint return) for the two years after the year of death of his or her spouse. § 2(a).

Territorial System

Where a government taxes only the income earned within its borders. The UK, Hong Kong, and France, for example, use a territorial approach, and the United States applies such rules on certain types of income.

One's average rate is

equal to the tax liability divided by taxable income.

The rates in the Tax Rate Schedules often are referred to as

statutory (or nominal) rates.

The marginal rate is

the highest rate that is applied in the tax computation for a particular taxpayer.