Individual Income Tax Computation Chapter 8
[LO 1] What is the tax marriage penalty and when does it apply? Under what circumstances would a couple experience a tax marriage benefit?
1.A marriage penalty (benefit) occurs when, for a given level of income, a married couple has a greater (lesser) tax liability when they use the married filing jointly tax rate schedule to determine the tax on their joint income than they would have owed (in total) if each spouse would have used the single tax rate schedule to compute the tax on each spouse's individual income. 2.The marriage penalty applies to couples with two wage earners with high incomes while a marriage benefit applies to couples with one breadwinner
[LO 1] What is a tax bracket? What is the relationship between filing status and the width of the tax brackets in the tax rate schedule?
1.A tax bracket is a range of taxable income that is taxed at a specified tax rate. Because only the income in the particular range is taxed at the specified rate, tax brackets are often referred to as marginal tax brackets or marginal tax rates. The level and width of the brackets depend on the taxpayer's filing status. The tax rate schedules include seven tax rate brackets. 2.In general, the tax brackets are widest for Married filing jointly (for example, more income is taxed at 10%), followed by Head of household, Single, and then Married filing separately
[LO 4] How are tax credits and tax deductions similar? How are they dissimilar?
1.A tax credit and a tax deduction both reduce a taxpayer's taxes payable. 2.However, a credit is more valuable than a deduction. 3.Though a deduction reduces taxable income, a tax credit reduces the taxes payable dollar-for-dollar.
13. [LO 2] Describe, in general terms, why Congress implemented the AMT.
1.Congress implemented the AMT to ensure that all taxpayers who were generating economic income paid some minimum amount of tax each year. 2.Prior to the AMT, the public perceived high-income taxpayers to be able to reduce or eliminate their total tax liability by taking excessive advantage of tax preference items such as exclusions, deferrals, and deductions. The AMT was designed as a response requiring these high-income taxpayers to pay at least some tax.
[LO 1] {Research} Are there circumstances in which preferentially taxed income (long-term capital gains and qualified dividends) is taxed at the same rate as ordinary income? Explain.
1.Generally, no. This is why we refer to the income as preferentially taxed income. 2.However, there are certain types of long-term capital gains that are taxed at a maximum rate of 25% and 28% (capital gains from collectibles). These gains are taxed at the taxpayer's marginal ordinary rate unless the ordinary rate exceeds the maximum rate. Then these gains are taxed at the maximum rate.
[LO 3] What are the primary factors to consider when deciding whether a worker should be considered an employee or a self-employed taxpayer for tax purposes?
1.In Rev. Rul. 87-41, 1987-1 CB 296, the IRS published a list of 20 factors to be considered when determining whether a worker should be classified as an independent contractor or as an employee. 2.Some of the major factors for making this determination include the following. Note that each factor is presented as though all other factors are held constant. (1). If the worker is able to set her own working hours it is more likely that she will be considered a contractor rather than an employee. (2). If the worker works for more than one firm at a time, she is more likely to be considered a contractor rather than an employee. (3). If the worker is at risk financially for recognizing a profit or loss, the worker is more likely to be considered a contractor rather than an employee. (4). If the worker is able to perform work somewhere other than the employer's premises, the worker is more likely to be considered a contractor rather than an employee. (5). If the worker is able to work without frequent oversight, she is more likely to be considered a contractor than an employee. (6). If the worker is able to work for more than one firm, the worker is more likely to be considered a contractor rather than an employee. 3.Note that these are only a few of all the possible factors to be considered. The determination is not made by adding the number of factors for each classification. Rather, the factors should be considered together in making the contractor - employee determination.
[LO 1] Does the kiddie tax apply to all children no matter their age? Explain.
1.No, the kiddie tax applies to children who have net unearned income in excess of $2,200 if the children (1) are under age 18 at the end of the year, (2) are age 18 at the end of the year and do not have earned income in excess of half of their support, or (3) are over age 18 and under age 24, are full-time students, and don't have earned income in excess of half of their support (excluding scholarships).
[LO 1] What is the kiddie tax? Explain.
1.The kiddie tax is a tax using the parent's marginal tax rate on the child's unearned income in excess of $2,200.
[LO 3] Bobbie works as an employee for Altron Corp. for the first half of the year and for Betel Inc. for rest of the year. She is relatively well paid. What FICA tax issues is she likely to encounter? What FICA tax issues do Altron Corp. and Betel Inc. need to consider?
1.Because Bobbie is well paid, it is likely that her wages for the year exceed the wage base for the Social Security component of the FICA tax. However, because she worked for two employers, each employer is required to withhold Social Security taxes from her paycheck until she exceeds the wage base with that particular employer. Consequently, it is likely that Bobbie will have more Social Security taxes withheld than she actually owes. She will be able to get this excess back when she files her form 1040 for the year. The excess Social Security tax paid is treated as a tax payment or credit by Bobbie that can be applied to offset her regular tax liability (and any other tax liability) and also generate a refund. 2.Bobbie will also need to use Form 8959 to determine her liability for the additional Medicare tax. Both Altron and Betel will withhold the Medicare tax at a rate of 1.45% on her salary or wages and the additional Medicare tax at a rate of .9% for any salary or wages above $200,000. Bobbie will report the additional Medicare tax withheld as a tax payment on Form 1040. 3.From the employer's perspective, both Altron and Betel must match Bobbie's Social Security payments until Bobbie exceeds the wage base with compensation from that particular company. In this situation, as noted, it appears that Bobbie will overpay her Social Security tax. However, while Bobbie gets the excess payment back, neither Altron nor Betel gets a refund for overpaying the employer's portion of Social Security taxes on Bobbie's behalf because each company paid proper tax for the amount Bobbie earned from each of them.
[LO 1] What is the difference between earned and unearned income?
1.Earned income is income earned by the taxpayer from services or labor. 2.Unearned income is from investment property such as dividends from stocks or interest from bonds.
[LO 3] Are an employee's entire wages subject to the FICA tax? Explain.
1.Employees must pay FICA taxes on their wages. This tax consists of a Social Security and a Medicare component. 2.The Social Security tax is intended to provide basic pension coverage for the retired and disabled. 3.The Medicare tax helps pay medical costs for qualified individuals. 4.The Social Security tax rate for employees is 6.2% of their salary or wages, and the Medicare tax rate for employees is 1.45%. The additional Medicare tax rate is .9% on salary or wages in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). 5.The wage base on which Social Security taxes are paid is limited to an annually determined amount. The 2020 limit is $137,700. Because there is no wage base for the Medicare component of the FICA tax, a taxpayer's entire wages will be subject to this portion of the FICA tax.
[LO 3] Compare and contrast an employee's FICA tax payment responsibilities with those of a self-employed taxpayer.
1.Employees must pay FICA taxes on their wages. This tax consists of a Social Security and a Medicare component. The Social Security tax is intended to provide basic pension coverage for the retired and disabled. The Medicare tax helps pay medical costs for qualifying individuals. The Social Security tax rate for employees is 6.2% of their salary or wages, the Medicare tax rate for employees is 1.45% of salary or wages, and the additional Medicare tax rate is .9% of salary or wages in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). The wage base on which Social Security taxes are paid is limited to an annually determined amount. The 2020 limit is $137,700. 2.While employees share their FICA tax burden with employers, self-employed taxpayers must pay the entire FICA tax burden on their self-employment earnings. Self-employed earnings equal 92.35% of net schedule C income. Just as it is with FICA taxes for employees, self-employed taxpayers are subject to both Social Security and Medicare taxes, and the base for the Social Security tax is limited to $137,700. The Social Security tax rate for self-employed taxpayers is 12.4% (6.2% employer share + 6.2% employee share). The Medicare tax rate for self-employed taxpayers is 2.9% on the taxpayer's self-employment income (1.45% employer share + 1.45% employee share). The additional Medicare tax is .9% of the taxpayer's self-employment income in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). 3.Finally, employees have their FICA tax payments withheld by their employers while self-employed taxpayers pay their FICA taxes with their estimated tax payments and with their tax return.
[LO 1] In 2020, for a taxpayer with $50,000 of taxable income, without doing any actual computations, which filing status do you expect to provide the lowest tax liability? Which filing status provides the highest tax liability?
1.For a taxpayer with $50,000, the married filing jointly filing status should provide the lowest tax liability in 2020 because the MFJ tax rate schedule taxes more of this income at 10% and 12% than the other rate schedules. 2.Conversely, the married filing separately and the single filing statuses will generate the highest tax liability because a smaller amount of income is taxed at 10% and 12% than other tax rate schedules.
[LO 3] How do the tax consequences of being an employee differ from those of being self-employed?
1.From the worker's perspective, the primary tax benefits of being classified as an independent contractor rather than an employee center on the deductibility of expenses. Independent contractors are able to deduct ordinary and necessary business expenses as "for" AGI deductions. This means the contractor may fully deduct the expenses. In contrast, business expenses incurred by employees are not deductible. While these factors appear to favor independent contractor status over employee status, employees generally don't incur many unreimbursed expenses relating to their employment. Thus, even though independent contractors may be able to deduct more expenses than employees, they typically incur more costs in doing business. 2.The primary tax cost for the person classified as an independent contractor rather than an employee is the payment of FICA taxes. Unlike independent contractors, employees share their FICA tax burden with employers. In contrast, self-employed taxpayers must pay the entire FICA tax burden on their self-employment earnings. Self-employed earnings equal 92.35% of net schedule C income. Just as it is with FICA taxes for employees, self-employed taxpayers are subject to both Social Security and Medicare taxes, and the base for the Social Security component of the self-employment tax is limited to $137,700. The Social Security tax rate for self-employed taxpayers is 12.4% (6.2% employer share + 6.2% employee share). The Medicare tax rate for self-employed taxpayers is 2.9% (1.45% employer share + 1.45% employee share). The additional Medicare tax rate for self-employed taxpayers is .9% on the taxpayer's self-employment income in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). 3.Contractors are allowed to deduct the employer portion of the self-employment (FICA) taxes they pay. This helps reduce the tax sting a little. Also, because independent contractors are not employees of the company, they are responsible for paying their own estimated taxes.
[LO 2] Do taxpayers always add back the standard deduction when computing alternative minimum taxable income? Explain. No
1.No. Taxpayers add back the standard deduction only if they deducted it when computing their regular taxable income (that is, they add it back when they did not itemize deductions).
[LO 1] Does the kiddie tax eliminate the tax benefits gained by a family when parents transfer income-producing assets to children? Explain.
1.No. Though the kiddie tax significantly limits the benefit of shifting income producing assets to children, it does not eliminate it. 2.The kiddie tax does not apply unless the child has unearned income in excess of $2,200 ($1,100 standard deduction plus an additional $1,100). 3.That is, parents can shift up to $2,200 of unearned investment income to a child without the child paying the kiddie tax
[LO 1] Once they've computed their taxable income, how do taxpayers determine their regular tax liability? What additional steps must taxpayers take to compute their tax liability when they have preferentially taxed income?
1.Once taxpayers have determined their taxable income, they should split the income into two portions: (1) ordinary income and (2) income taxed at preferential rates (if any), and compute tax on each portion separately. 2.Taxpayers compute the tax on the ordinary income portion by applying the appropriate tax rate schedule (based on their filing status). 3.For dividends and capital gains taxed at preferential tax rates, the preferential tax rate is 0 percent, 15 percent, or 20 percent. The preferential tax rates vary with the taxpayer's filing status and income as determined by tax brackets specific for preferential income. See Appendix D for the tax brackets by filing status that apply to preferentially taxed capital gains and dividends. 4.A taxpayer's total regular income tax liability is the sum of the tax on ordinary income and the tax on preferentially taxed income.
[LO 4] What are the three types of tax credits? Explain why it is important to distinguish between the different types of tax credits.
1.Tax credits are generally classified into one of three categories: nonrefundable personal, refundable personal, or business credits depending on the target for and purpose of the credit. 2.The type of credit is important because credits are applied against the gross tax in a specified order and this determines whether any excess (unused) credit will be lost (nonrefundable personal credits), carried over into another period (business credits), or refunded.
[LO 2] The starting point for computing alternative minimum taxable income is regular taxable income. What are some of the plus adjustments, plus or minus adjustments, and minus adjustments to regular taxable income to compute alternative minimum taxable income?
1.Taxpayers first add back to regular taxable income the standard deduction amount, but only if they deducted it in determining taxable income. 2.Taxpayers are then required to make several adjustments to compute AMTI. Exhibit 8-3 describes the most common of these adjustments
[LO 2]. Describe what the AMT exemption is and who is and isn't allowed to deduct the exemption. How is it similar to the standard deduction and how is it dissimilar?
1.The AMT exemption ensures that most taxpayers aren't subject to the AMT. The amount of the exemption is subject to the taxpayer's filing status (Exhibit 8-5) and is available to all taxpayers. 2.Like the standard deduction, the AMT exemption reduces the taxpayer's tax base. 3.However, unlike the standard deduction, the AMT exemption is phased-out for high income taxpayers. 4.Further, taxpayers don't deduct the standard deduction if they itemize but taxpayers would deduct the AMT exemption amount in any circumstance (unless it was phased-out).
[LO 2] In very general terms, how is the alternative minimum tax system different from the regular income tax system? How is it similar?
1.The AMT system is different in that it taxes a more broad or inclusive tax base than the regular income tax. The AMT is designed to tax an income base that more closely reflects economic income than does the regular income tax system. Many items that are deductible for regular tax purposes are not deductible for AMT purposes. Further, certain types of income included in the AMT base are not included in the regular income tax base. 2. The AMT system is similar to the regular tax system in that the starting point for computing the AMT tax base is regular taxable income. The AMT system is also an income tax system that allows certain deductions from the income tax base.
[LO 4] Explain why there are such a large number and variety of tax credits.
1.The proliferation of credits is partly because credits provide a dollar-for-dollar reduction in taxes. That is, credits do not provide a disproportionate incentive for taxpayers with the highest marginal tax rates. Credits are also extremely flexible in that they can be used to provide incentives for transactions that are not easily addressed by adjustments to the tax base. Hence, credits are powerful tools for accomplishing policy objectives because they have a direct influence on the tax and the strength of the influence can be adjusted without changing the tax rate.
[LO 1] Augustana received $100,000 of qualified dividends this year. Under what circumstances might the entire $100,000 of income not be taxed at the same rate?
1.The qualified dividend will be taxed at different rates if the amount of Augustana's taxable income including the dividend (e.g., $500,000) falls within a different preferential tax bracket than her taxable income excluding the dividend (e.g., $400,000). 2.In this scenario, part of qualified dividends will be taxed at 20% and part will would be taxed at 15%.
[LO 2] What is the difference between the tentative minimum tax (TMT) and the AMT?
1.The tentative minimum tax is the AMT base multiplied by the AMT rates. 2.The AMT is the excess of the TMT over the taxpayer's regular tax liability for the year. 3.Thus, taxpayers only pay AMT to the extent their TMT exceeds their regular tax liability.
[LO 3] {Planning} Mike wanted to work for a CPA firm, but he also wanted to work on his father's farm in Montana. Because the CPA firm wanted Mike to be happy, it offered to let him work for the firm as an independent contractor during the fall and winter and return to Montana to work for his father during the spring and summer. He was very excited to hear that the firm was also going to give him a 5 percent higher "salary" for the six months he would be working for the firm over what he would have made over the same six-month period if he worked full time as an employee (i.e., an increase from $30,000 to $31,500). Should Mike be excited about his 5 percent raise? Why or why not? What counter offer could Mike reasonably suggest?
1.This offer may not be as great of a deal as it sounds for Mike. While Mike is getting a 5% higher salary as an independent contractor, he will be responsible for paying his full FICA tax. 2.Assuming Mike's pay is under the Social Security cap, Mike will be required to pay 6.48% more in Social Security taxes than he would have had to pay as an employee [i.e., (15.3% x .9235) - 7.65%]. Mike is also allowed to deduct the employer share of his self-employment taxes as a "for" AGI deduction. This reduces the difference a little. 3.Given Mike's likely marginal tax rate for federal income tax purposes, the Social Security taxes alone means that Mike would have done better as an employee. Further, as a contractor, Mike is not eligible for other benefits available to employees like health insurance, life insurance, and retirement savings contributions. 4.Thus, Mike's 5% higher salary should not necessarily be cause for excitement. Note, however, as an independent contractor, he may be able to deduct premiums for health insurance and retirement savings contributions as "for" AGI deductions. Further, Mike has more control over his schedule as an independent contractor and he is able to do the things he wants to do. These attributes should offset some of the disadvantages of independent contractor status. 5.An appropriate counteroffer for Mike should take into account the full difference in FICA taxes he will pay as an independent contractor as well as the benefits that he will be foregoing as an independent contractor.
[LO 1, LO 2] How do the AMT tax rates compare to the regular income tax rates?
1.Though both tax systems use a progressive tax rate schedule, AMT has only two stated marginal rates: 26% and 28%. 2.In contrast, the regular tax system has stated marginal tax rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%. 3.However, the preferential rates for long-term capital gains and qualified dividends apply to both the AMT system and the regular tax system.
[LO 3] When a taxpayer works as an employee and as a self-employed independent contractor during the year, how does the taxpayer determine her employment and self-employment taxes payable?
1.When a taxpayer earns employee compensation and generates self-employment income in the same year, the taxpayer first pays Social Security tax on the employee compensation (up to the limit or wage base) at 6.2% and then the taxpayer pays Social Security tax at 12.4%. 2.The full amount of both the salary and net self-employment income are subject to the Medicare tax
[LO 1] Lauren is 17 years old. She reports earned income of $3,000 and unearned income of $6,200. Is it likely that she is subject to the kiddie tax? Explain.
1.Yes, Lauren is under age 18 at year end and her unearned income exceeds $2,200, so she is subject to the kiddie tax. 2.Note that the kiddie tax base is the child's net unearned income. Net unearned income is the lesser of the child's gross unearned income minus $2,200 or the child's taxable income. 3.In this case, Lauren's taxable income is calculated as $9,200 gross income less her standard deduction of $3,350= $5,850. Her gross unearned income minus $2,200 is calculated as $6,200 less $2,200 = $4,000, which would be taxed at her parents' marginal tax rate. The remaining $1,850 would be taxed Lauren's regular tax rate of 10%.
[LO 2] Is it possible for a taxpayer who pays AMT to have a marginal tax rate higher than the stated AMT rate? Explain.
1.Yes, taxpayers in the exemption phase-out range pay a higher marginal rate because each dollar of income decreases their exemption by 25 cents. 2.Thus, taxpayers in the exemption phase-out range receiving one dollar of income must increase their AMT tax base by $1.25. If they are paying AMT at the stated 26% rate, their marginal tax rate is effectively 32.5% (26% x 1.25).
