Federal Income Taxation Chp. 4

Using the tax rate schedule, what would be the Hall's tax liability if their income were $12,000 (all ordinary income)?

$12,000 * 10% = $1,200

Assume in addition to the $101,600 of ordinary income, the Hall's also reported $5,000 of long-term capital gain subject to a 15% tax rate. How much tax would they pay on the additional $5,000 gain?

$5,000 * 15% = $750 Long-term capital gains (gains on sale of capital assets held longer than a year) are generally taxed at 15% Note that the Hall's taxable income is $101,600 (taxed at ordinary) and $5,000 is taxed at preferential percent rate

The Hall's also determined that all of their income is ordinary. What is their tax liability?

(22 * ($101,600 - $77,400)) = $5,324 $5,324 + $8,907 = $14,231 (based on MFJ tax rate schedule)

A loss on the sale of a capital asset

(no matter how long the taxpayer holds the asset before selling) generates a deduction for the taxpayer in the year of sale (a for AGI deduction, as discussed below). However, the deduction for the loss is limited to $3,000 for the year (losses in excess of the limit are carried forward indefinitely). If the taxpayer sells a personal-use asset (like a personal automobile or personal residence) at a loss, the loss is not deductible.

Tax Prepayments include:

1) withholdings, or income taxes withheld from the taxpayer's salary or wages by her employer; (2) estimated tax payments, the taxpayer makes for the year (paid directly to the IRS), and (3) taxes the taxpayer overpaid on the prior year tax return that the taxpayer elects to apply as an estimated payment for the current tax year instead of receiving the overpayment as a refund.

To qualify as a dependent of another, an individual:

1. Must be a citizen of the United States or a resident of the United States, Canada, or Mexico 2. Must not file a joint return with the individual's spouse unless there is no tax liability on the couple's joint return and there would not have been any tax liability on either spouse's tax return if they had filed separately 3. Must be considered either a qualifying child of the taxpayer or a qualifying relative of the taxpayer.

Under a multiple support agreement, taxpayers who don't pay over half of an individual's support may still be allowed to claim the individual as a dependent under the qualifying relative rules if the following apply

1. No one taxpayer paid over one-half of the individual's support. 2. The taxpayer and at least one other person provided more than half the support of the individual, and the taxpayer and the other person(s) would have been allowed to claim the individual as a dependent except for the fact that they did not provide over half of the support of the individual. 3. The taxpayer contributed over 10 percent of the individual's support for the year. 4. Each other person who provided over 10 percent of the individual's support (see requirement (2) above) provides a signed statement to the taxpayer agreeing not to claim the individual as a dependent. The taxpayer includes the names, addresses, and Social Security numbers of each other person on Form 2120, which the taxpayer attaches to her Form 1040.

A qualifying family relationship with the taxpayer includes the following:

A descendant or ancestor of the taxpayer. For this purpose, a child includes a taxpayer's adopted child, stepchild, and eligible foster child; and a parent includes a stepmother and stepfather. A sibling of the taxpayer, including a stepbrother or a stepsister. A son or daughter of the brother or sister of the taxpayer (cousins do not qualify). A sibling of the taxpayer's mother or father. An in-law (mother-in-law, father-in-law, sister-in-law, brother-in-law, son-in-law, or daughter-in-law) of the taxpayer. A person meets the qualifying relative "member of the household" test if that person has the same principal place of abode as the taxpayer for the entire year (even if the person does not have a qualifying family relationship with the taxpayer).

Relationship test.

A qualifying child must be an eligible relative of the taxpayer. Eligible relatives include the taxpayer's :Child or descendant of a child. For this purpose, a child includes a taxpayer's adopted child, stepchild, and eligible foster child. Sibling or descendant of sibling. For this purpose, a sibling includes a taxpayer's half-brother, half-sister, stepbrother, or stepsister. Under this definition, the taxpayer's grandchild would qualify as an eligible relative as would the taxpayer's sister's grandchild.

Age test.

A qualifying child must be younger than the taxpayer and either (1) under age 19 at the end of the year or (2) under age 24 at the end of the year and a full-time student. A person is a full-time student if she was in school full-time during any part of each of five calendar months during the calendar year. An individual (of any age) who is permanently and totally disabled is deemed to have met the age test

Residence test.

A qualifying child must have the same principal residence as the taxpayer for more than half the year. Time that a child (or the taxpayer) is temporarily (not permanently) away from the taxpayer's home because the child (or taxpayer) is ill, is pursuing an education, or has other special circumstances is counted as though the child (or taxpayer) were living in the taxpayer's home

Support test

A qualifying child must not have provided more than half of his or her own support (living expenses) for the year. Support generally includes: Food, school lunches, toilet articles, and haircuts. Clothing. Recreation—including toys, summer camp, horseback riding, entertainment, and vacation expenses. Medical and dental care. Child care expenses. Allowances and gifts. Wedding costs. Lodging. Education- including board, uniforms at military schools, and tuition, but determining who provided the support for a taxpayer's child who is a full-time student, scholarships are excluded from the computation

Qualifying Relative

A qualifying relative is a person who is not a qualifying child and satisfies (1) a relationship test, (2) a support test, and (3) a gross income test.

A friend helps the Hall's with their taxable income to be $101,600 computed as follows:

Adjusted gross income: $125,600 From AGI deductions: $(24,000) Taxable income: $101,600

Tax Prepayments

After calculating the total tax and subtracting their available credits, taxpayers determine their taxes due (or tax refund) by subtracting tax prepayments from the total tax remaining after credits. If tax prepayments exceed the total tax after subtracting credits, the taxpayer receives a tax refund (or elects to apply the refund as an estimated tax payment) for the difference. If tax prepayments are less than the total tax after credits, the taxpayer owes additional tax and potentially a penalty for the underpayment.

Income Tax Calculation

After determining taxable income, taxpayer's can calculate their regular income tax liability using either a tax table or a tax rate schedule, depending on filing status and income level Those who have income of $100,000 or less must use the tax tables

Partial listing of common for AGI deductions

Alimony paid (pre 2019 decree) Health insurance deduction for self-employed taxpayers Rental and royalty expenses Capital losses (net loss limited to $3,000 for the year) One-half of self-employed taxes paid Business expenses Losses on dispositions of assets used in trade or business Contributions to qualified retirement accounts (401k & individual retirement accounts, or IRA)

Rodney earned a salary of $74,000, and Anita earned a salary of $56,000. The halls also received $600 of interest income from investments in corporate bonds and $300 of interest income from investments in municipal bonds. This was their only realized income during the year. What is the Hall's gross income?

Answer: $130,600 computed as follows: Rodney's Salary: $74,000 Anita's Salary: $56,000 Interest from corporate bonds: $600 $74,000+$56,000+$600 = $130,600

Tax Provisions

Certain tax provisions allow taxpayers to permanently exclude specific types of realized income from gross income (excluded income items are never taxable) and other provisions allow taxpayers to defer including certain types of realized income items in gross income until a subsequent year (deferred income items are included in gross income in a later year).

Rodney made $5,000 deductible (for AGI) contribution to his individual retirement account (IRA) What is the Hall's adjusted gross income?

Gross income: $130,600 IRA contribution: $(5,000) Adjusted gross income: $125,600

long term capital gain

If the gain is a long-term capital gain, it is taxed at a 15 percent tax rate (20 percent for high income taxpayers and 0 percent for low income taxpayers).

Other Taxes

In addition to the individual income tax, individuals may also be required to pay other taxes such as the alternative minimum tax (AMT) or self-employment taxes

Personal and Dependency Exemptions

Individual taxpayers generally may deduct a personal exemption for themselves Married couples filing jointly may claim two personal exemptions (one for each spouse) a taxpayer may claim an additional exemption for each person who qualifies as the taxpayer's dependent Individuals who qualify as a dependent of another taxpayer may not claim a personal exemption for themselves on their own individual tax returns and they may not claim a dependency exemption for someone else

Partial listing of common deferrals items

Installment sale Like-kind exchange

Partial listing of common exclusions items

Interest income from municipal bonds Gift and inheritance Gain on sale of personal residence Life insurance proceeds

Suppose this year the Hall's sold shares of stock in XYZ Corporation at a $4,000 gain (their only transaction involving a capital asset). They purchased the stock three years ago. What would be the character of gain? At what rate would it be taxed?

It's a long-term capital gain because stock is a capital asset and the Hall's owned the stock for more than a year before selling. Given their income level, the gain would be taxed at a maximum rate of 15%

What if they sold the stock at $4,000 loss (their only transaction involving a capital asset). They purchased the stock three years ago. What would be the character of loss? How much of the loss can be deducted?

It's a long-term capital loss because stock is a capital asset and the Hall's owned the stock for more than a year before selling. The Hall's can deduct $3,000 of the loss as a for AGI deduction this year. The remaining loss of $1,000 is carried over to next year

What if they sold a personal automobile at a $4,000 loss. They purchased the automobile three years ago. What would be the character of loss? How much of the loss can be deducted?

It's a long-term capital loss because the automobile is a capital asset and the Hall's owned the auto for more than a year before selling. But, they are not allowed to deduct any of the $4,000 loss this year or any year because the automobile is a personal-use asset.

Rodney and Anita Hall annually file a MFJ tax return. They paid $11,000 for expenditures that qualified as itemized deductions and they had no qualified business income (QBI). What is the total amount of from AGI deductions Rodney and Anita are allowed to deduct on their tax return?

MFJ status: $24,000 Itemized deductions: $11,000 Greater of either: $24,000 (standard deduction exceeds itemized deduction) QBI deduction $0 Total deductions from AGI: $24,000 ($24,000 + $0)

Instead, what if Rodney and Anita paid $11,000 in expenditures that qualified in itemized deductions and they were allowed to claim a $1,000 QBI deduction based on $5,000 of qualified business income they reported?

MFJ status: $24,000 Itemized deductions: $11,000 Greater of either: $24,000 (standard deduction exceeds itemized deduction) QBI deduction: $1,000 ($5,000*20%) Total deductions from AGI: $25,000 ($24,000 + $1,000)

Instead, what if Rodney and Anita paid a total amount of $28,000 in expenditures that qualified as itemized deductions?

MFJ status: $24,000 Itemized deductions: $28,000 Greater of either: $28,000 (itemized exceeds standard) QBI deduction: $0 Total deductions from AGI: $28,000 ($28,000 + $0)

Special rules may alte the allowable standard deduction for certain taxpayer's

Married taxpayer's 65 or older and or blind get an additional deduction of $1,300 ($1,300 for age and another $1,300 for blindness) Single & head of household taxpayer's 65 or older and or blind get an additional deduction of $1,600 ($1,600 for age and another $1,600 for blindness) Those dependent on another tax return, the standard 2018 deduction is the greater of: 1) $1,050 or 2) $350 plus earned income not exceed the standard deduction amount for those who aren't dependents

Primary categories of itemized deductions

Medical and dental expenses: deducts to the extent if these expenses exceed 7.5% of AGI Taxes: State and local income taxes, sales taxes, real estate taxes, personal property taxes, and others (aggregate $10,000 deduction limitation applied to taxes) Interest expenses: Mortgage and investment interest expense Gifts to charity: charitable contributions Other miscellaneous deductions: Gambling losses (extent of gambling winnings) and certain other deductions

Suppose Shawn is Rodney's cousin. Would Braxton be considered Shawn's qualifying child?

No. Braxton does not meet the relationship test for Shawn as Braxton is not a descendant of Shawn's sibling

Assume if Tara is age 25. Would she be a qualifying dependent child of her parents?

No. She fails the age test. She could still qualify as her parent's dependent as a qualifying relative

Suppose Tara supported more than half of her own support. Would she be considered a qualifying child of her parents?

No. She would fail the support test

The most common characters of income are as follows:

Ordinary Capital

From AGI Deductions

Referred to as deductions below the line (deducted after AGI has been determined, which is on page 2 of form 1040) tend to be personal in nature Years prior 2018, included itemized deductions, the standard deduction, personal and dependency exemptions Beginning 2018 new tax law added a from AGI deduction that is generally equal to 20% of a taxpayer's qualified business income (QBI) and eliminates deductions for personal and dependency exemptions QBI is not an itemized deduction, THEREFORE individuals have the choice of deducting either their itemized deductions or a fixed amount called the standard deduction. People usually deduct the higher standard deduction or itemized deduction

Under the tiebreaker rules who is allowed to claim Braxton as a dependent for the year?

Rodney and Anita (parents)

What is the character of salary, the interest income from the corporate bonds, and the interest income from the investments in municipal bonds?

Salary and interest income from corporate bonds are ordinary income. Interest income from the municipal bonds is excluded from gross income.

Qualified dividend:

Shareholders receiving dividends from corporations include the dividend income in gross income. If the dividend meets the qualified dividend requirements, it is taxed at a rate of 15 percent (20 percent for high income taxpayers and 0 percent for low income taxpayers). If a dividend does not meet the qualified dividend requirement, it is taxed at ordinary rates.

Self-employment taxes

Social Security and Medicare taxes paid by the self-employed on a taxpayer's net earnings from self-employment. For self-employed taxpayers, the terms "self-employment tax" and "FICA tax" are synonymous. Taxpayer's with high AGI are subject to 3.8% net investment income tax on unearned (investment) income and a 0.9% Medicare tax on earned income

Rodney and Anita tax liability is $14,231. They had $12,100 of federal income taxes withheld by their employers from their paychecks and are able to claim a $2,000 child tax credit for their 12 year old son Braxton and a $500 child tax credit for Tara. What is the Hall's tax due or tax refund?

Tax liability: $14,231 Tax credits: $(2,500) Tax prepayments: $(12,100) Tax refund: $369 (Add them all together)

adjusted gross income (AGI)

The last line on page 1 of Form 1040 gross income less deductions for AGI. AGI is an important reference point that is often used in other calculations.

Capital

These are gains or losses on the disposition or sale of capital assets. In general, capital assets are all assets other than 1. Accounts receivable from the sale of goods or services. 2. Inventory and other assets held for sale in the ordinary course of business. 3. Assets used in a trade or business, including supplies. Nonbusiness assets such as personal-use automobiles or personal residences and assets held for investment such as stocks and bonds are capital assets.

ordinary

This is income or loss that is taxed at the ordinary rates provided in the tax rate schedules in Appendix D, or offsets income taxed at these rates, and is not capital in character.

Character of Income

While gross income increases taxable income dollar for dollar, it is important to note that certain types of income are treated differently than other types of income for purposes of computing a taxpayer's taxable income and income tax liability. The type of income is commonly referred to as the character of income. Types of incomes are taxed at different rates

qualified dividends

While qualified dividends are taxed at the same rate as long-term capital gains, qualified dividends are not included in the capital gain and loss netting process. Therefore, qualified dividend is a separate and distinct character from capital.

Rodney and Anita have 2 kids: Braxton (12), who lives at home, and Tara (21), who is a full-time student and does not live at home. Tara earned $9,000 from a summer job, but she did not provide more than half of her own support during the year. Are Braxton and Tara qualifying dependent children of Rodney and Anita?

Yes, they both meet all the requirements as qualifying children and therefore, are dependents of the Hall's

What if Braxton's Uncle Shawn - Rodney's brother - lived in the Hall's home (the same home Braxton lived in) for more than 11 months during the year. Does Braxton meet the requirements to be considered Shawn's qualifying child?

Yes. Braxton is the son of Shawn's brother. Under 19 and younger than Shawn, lived in same residence as Shawn for more than half the year, and does not provide more than half of his own support Braxton is considered to be Rodney's and Anita's qualifying child and considered to be Shawn's qualifying child.

Assume if Braxton is Anita's stepbrother's son. Would Braxton be considered a qualifying dependent child of Rodney and Anita?

Yes. He meets the relationship test because he is a descendant of Anita's stepbrother (sibling)

Standard deduction

a fixed deduction offered in lieu of itemized deductions. The amount of the standard deduction depends on the taxpayer's filing status. Used for indexed for inflation New tax law for 2018 increased significantly for standard deduction amounts

dependents

a person for whom a taxpayer may claim a dependency exemption. To qualify as a dependent a person must be a qualifying child or qualifying relative of the taxpayer.

Alternative minimum tax (AMT)

a tax on a broader tax base than the base for the "regular" tax; the additional tax paid when the tentative minimum tax (based on the alternative minimum tax base) exceeds the regular tax (based on the regular tax base). The alternative minimum tax is designed to require taxpayers to pay some minimum level of tax even when they have low or no regular taxable income as a result of certain tax breaks in the tax code.

Itemized deductions

certain types of expenditures that Congress allows taxpayers to deduct as from AGI deductions.

The tax laws provide for two distinct types of deductions in the individual tax formula:

for adjusted gross income (AGI) deductions and from AGI deductions Congress identifies whether the deductions are for or from AGI when it enacts new legislation that grants deductions.

Support test

generally requires that the taxpayer pay more than half the qualifying relative's living expenses (food, rent, medicine, clothing, others) scholarships are excluded for full-time students Multiple support agreements are commonly used in situations when siblings support elderly parents.

Realized income

income generated in a transaction with a second party in which there is a measurable change in property rights between parties. EX: appreciation in a stock investment would not represent realized income unless the taxpayer sold the stock

Preferentially taxed income

income taxed at a preferential rate such as long-term capital gains and qualified dividends.

Qualifying Child

individual must satisfy the following four tests: (1) relationship, (2) age, (3) residence, and (4) support.

Tax Credits

items that reduce a taxpayer's tax liability dollar for dollar tax credits directly reduce taxes payable (granted by Congress and narrowly defined) a $1 deduction reduces taxes payable by $1 times the marginal tax rate while a $1 credit reduces taxes payable by $1 Common credits include the child tax credit ($2,000 per child that qualifies for the credit, under 17 year-end, and a $500 credit for other qualifying dependents), the child and dependent care credit, the earned income credit, the American opportunity credit, and the lifetime learning credit.

Capital gains are further characterized as:

long-term (when the taxpayer owns the capital asset for more than one year before selling it) or as short-term (when the taxpayer owns the capital asset for one year or less before selling it) A gain on a sale of a capital asset is generally included in gross income.

Relationship test

more inclusive than the relationship test for a qualifying child- meets the test if: the person either (1) has a qualifying family relationship with the taxpayer or (2) meets the qualifying relative "member of the household" test

Tiebreaking rules

possible that one person could be a qualifying child to more than one taxpayer the taxpayer who has priority for claiming the dependency exemption is based on the following tiebreaking rules: 1). If the person is a qualifying child of a parent, the parent is entitled to the dependency exemption for the child. This situation could arise, for example, when a child lives with her mother and her grandparents. In this case, the mother has priority for claiming the dependency exemption over the grandparents. 2). If the individual is a qualifying child to both parents, the parent with whom the child has resided for the longest period of time during the year has priority. This situation may arise in a year when the child lives with both parents for more than half of the year, but the parents separate or divorce in the latter part of the year. Note, however, that the dependency exemption for a child of divorced parents can be claimed by the noncustodial parent if the custodial parent (the parent entitled to claim the exemption) releases the exemption to the noncustodial parent through a written declaration and the noncustodial parent attaches the declaration to his or her tax return. 3). Finally, if the child resides with both parents for the same amount of time during the year or the qualifying child resides with a taxpayer who is not the child's parent, the taxpayer with the highest AGI has priority for claiming the dependency exemption for the child.

Deferrals

realized income items that taxpayers include in gross income in a subsequent year

Exclusions

realized income items that taxpayers permanently exclude from taxation

Gross Income

realized income reduced for any excluded or deferred income. OR all realized income from whatever source derived

Deductions

reduces a taxpayer's taxable income (hard to come by because deductions are not allowed unless a specific tax law allows them, thus making them a legislative grace). amounts that are subtracted from gross income in calculating taxable income. taxpayers are not allowed to deduct anything unless a specific tax provision allows them to do so deductions are a matter of legislative grace

Preferential tax rate

tax rates lower than the tax rate applied to ordinary income. Because qualified dividends (and long-term capital gains) are taxed at a preferential tax rate (a rate lower than the ordinary income rate), qualified dividends (and long-term capital gains) can be referred to as preferentially taxed income.

For AGI Deductions

tend to be deductions associated with business activities and certain investing activities reduces AGI (page 1 form 1040) is referred to deductions above the line Moving expenses removed for AGI deduction (besides military)

Legislative grace

the concept that taxpayers receive certain tax benefits only because Congress writes laws that allow taxpayers to receive the tax benefits.

tax Form 1040

the form individuals generally use to report their taxable income

short term capital gain

the gain is taxed at ordinary income rates. Note that even though a short-term capital gain is taxed at ordinary rates, it is still considered to be a capital gain and not ordinary income.

When a taxpayer sells more than one capital asset during the year

the gains and losses are netted together. A net loss is subject to the $3,000 annual deduction limit. A net gain may be taxed at 15, 20, or 0 percent or at the ordinary rates depending on the outcome of the netting process and the taxpayer's taxable income.

Taxable income

the tax base for the individual income tax to the IRS