Income Tax Fundamentals and Calculations
Refundable credit
Not only offsets a taxpayer's income tax liability but, if the refundable credits exceed the taxpayer's tax liability, the government will refund this excess to the taxpayer Principal type of refundable credit is the earned income credit
3 rules used to determine whether the kiddie tax applies
1) Prior to the year a child turns 18, the kiddie tax applies if the unearned income exceeds the $1,050 threshold 2) For the year the child turns 18 (and only that year), the kiddie tax applies if the child's earned income is less than or equal to one-half of his/her support and unearned income exceeds the $1,050 threshold 3) From the year that a child turns 19 up to and including the year the child turns 23, the kiddie tax applies only if a child is a full-time student, the child's earned income is less than or equal to one-half of his/her support, and unearned income exceeds the $1,050 threshold
Standard deduction unavailable for 3 categories of taxpayers
1) an individual filing a return for a period less than 12 months because of a change in accounting period 2) a married taxpayer filing a separate return in instances where the other spouse itemizes 3) non-resident aliens
Itemized deduction floors
1) medical expenses-- must be over 10% of AGI 2) casualty losses-- must exceed 10% of AGI 3) misc itemized deductions-- in excess of 2% 4) high-income taxpayers-- must reduce total itemized deductions AGI floors represent amounts in which he deduction is allowable only if it exceeds the floor amount
Joint return
A joint return can be filed by a man and woman if they meet certain tests: 1) must be legally married as of the last day of the tax year joint return can be filed if one spouse dies during the year as long as the survivor does not remarry before year-end 2) they must have the same tax year-end 3) both must be a US citizen exception allows a joint return if the nonresident alien spouse agrees to report all of his/her income on the return
Tax credit for the elderly
A limited, personal, non-refundable credit is provided for certain low-income elderly individuals who have attained the age of 65 before the end of the tax year and individuals who retire because of permanent and total disability who receive insubstantial Social Security benefits The maximum credit is 15% times an initial amount of $5000 ($7500 for married individuals filing jointly if both spouses are 65 or older) Initial amount is reduced by: 1) Social security, railroad retirement, or Veterans' Administration pension or annuity benefits that are excluded from gross income 2) One-half of AGI in excess of $7500 for a single individual ($10,000 for married taxpayers filing a joint return)
Adoption credit
A nonrefundable credit is allowed for qualified adoption expenses—amount of credit in 2016 is limited to a maximum of $13,460 (including a child with special needs) and generally is allowable in the year the adoption is finalized If the adoption expenses are paid or incurred in a year subsequent to the year the adoption is finalized, the credit is allowable in such later year If adoption expenses are paid prior to the year the adoption is finalized, such expenses are deductible in the year the adoption is finalized There is a phase-out of the credit based on AGI-- for taxpayers in 2016 with AGI between $201,920 and $241,920, the credit is ratable phased out Taxpayers adopting a special needs child are treated as having incurred qualified adoption expenses of $13,460 even if actual expenses are less Qualified adoption expenses include: 1) Reasonable and necessary adoption fees 2) Court costs 3) Attorney fees, and 4) Other expenses that are directly related to the legal adoption of an eligible child-- eligible child is defined as a child who has not reached the age of 18 when the adoption takes place or is physically or mentally incapable of self-care
Age test
A qualifying child must be under age 19, a full time student under age 24, or a permanently and totally disabled child
Abode test
A qualifying child must have the same principal above as the taxpayer for more than half of the year A noncustodial parent meets this requirement if the custodial parent agrees in writing
Exclusion
A source of income that is omitted from the tax base Any item of income that tax law treats as nontaxable Major exclusions: gifts and inheritances, life insurance proceeds, welfare, certain scholarships and fellowships, certain payments for injury and sickness, certain employee fringe benefits, certain foreign-earned income, interest on state and local government bonds, certain interest of Series EE bonds, certain improvements by lessee to lessor's property, child support payments, property settlements pursuant to a divorce, and gain from the sale of a personal residence
Surviving spouse
A widow or widower can file a joint return for the year his/her spouse dies if the widow or widower does not remarry For the 2 years after the year of the death, the widow or widower can file as a surviving spouse only if he/she meets specific conditions: 1) Have not remarried as of the year-end in which surviving spouse status is claimed 2) Be a U.S. citizen or resident 3) Have qualified to file a joint return in the year of death 4) Have at least 1 dependent child living at home during the entire year and the taxpayer must pay over half of the expenses of the home In the year of death, a joint return can be filed—income of the deceased spouse (earned before death) and the survivor are both reported-- personal exemptions are allowed for both spouses
Taxable income
AGI reduced by deductions from AGI The amount of income that is taxed
Deductions for AGI
Allowable deductions include business expenses, investment expenses, or personal expenses that are specifically provided for in the IRC Generally deductions for AGI are expenses connected with trade or business Ex:) trade and business deductions, reimbursed employee expenses, losses from the sale or exchange of property, deductions attributable to rents and royalties, certain deductions of life tenants and income beneficiaries of property, contributions to retirement plans, penalties forfeited because of premature withdrawal of funds from time savings accounts, 1/2 of self-employment taxes paid, portion of health insurance costs incurred by a self-employment person, alimony, moving expenses, certain required payments of supplemental unemployment compensation, jury duty pay remitted to an individual's employer, certain environmental expenditures, interest on education loans and, contributions to medical savings account and HSAs More valuable-- deductions include trade or business expenses, expenses relating to property held for the production of income (rental property) alimony, IRA contributions, net capital losses, and certain others
Personal exemptions
Almost every individual taxpayer is allowed a personal exemption, which is $4,050 in 2016 If there are 2 taxpayers on a joint return filed by a married couple, they are allowed 2 personal exemptions If a married person files a separate return, the taxpayer can claim a personal exemption for his/her spouse if the spouse has no gross income during the year and the spouse is not the dependent of another taxpayer Under current law, only 1 exemption is allowed for each person
Standard deduction
Amount varies depending on the taxpayer's filing status, age, and vision/eyesight For most taxpayers, the standard deduction is greater than the total itemized deductions Single: $6300 Married filing jointly: $12600 Married filing separately: $6300 Heads of household: $9250 Married taxpayer's standard deduction is increased by $1250 if he/she is elderly or blind If unmarried his/her deduction increased by $1550
Credits and prepayments
Amounts that can be subtracted from the gross tax to arrive at the net tax due or refund due Refundable tax credits—are allowed to reduce a taxpayer's tax liability to 0 and if some credit still remains are refundable (paid) by the government to the taxpayer Prepayments of tax, which are amounts paid to the government during the year through which means such as withholding from wages and selected other items are also classified as refundable tax credits Nonrefundable tax credits—allowances that have been created by Congress for various social, economic, and political reasons such as the child and dependent care credit They can be subtracted from the tax and may reduce the tax liability to 0 If the nonrefundable credits exceed the tax liability, none of the excess will be paid to the taxpayer
Withholding
An employer must withhold federal income taxes and FICA taxes from an employee's wages Withholding is required on all forms of remuneration paid to an employee-- salaries, fees, bonuses, dismissal payments, commissions, vacation pay, and taxable fringe benefits
Single taxpayer
An unmarried individual who does not qualify as a surviving spouse or a head of household must file as a single taxpayer Tax rates are higher than those that apply to other married taxpayers
Income
Both taxable and non-taxable Includes income from any source Does not include "return of capital"
Alternative motor vehicle credit
Congress has enacted several nonrefundable personal credits to encourage taxpayers to invest in alternative vehicles Comprehensive (AMVC) contains the: Qualified fuel cell credit Advanced lean-burn technology credit Qualified hybrid credit Qualified alternative fuel refueling property credit Plug-in conversion credit Plug-in electric vehicle credit
Lifetime learning credit
Credit is 20% of a maximum of $10,000 per year of qualified tuition and fees paid by the taxpayer for one or more eligible students $10,000 limitation is imposed at the taxpayer level, not on a per student basis Available for an unlimited number of years and may be used for undergraduate, graduate, and professional degree expenses Lifetime learning credit and AOTC may not be taken in the same tax year with respect to the same student's tuition and related expenses
Personal credits
Credits are allowed as an offset against an individual's tax liability before all other nonrefundable credits Most personal tax credits have been enacted for social welfare rather than economic reasons Most common: child and dependent care, child tax credit, American opportunity and lifetime learning tax credits
Tax rates
Currently 7 individual income tax rates: 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%
Gross income
Everything of value received by a taxpayer during the taxable year unless it is established that it is not income Gross income items: compensation for services, gross income derived from dealings in property, gains derived from dealings in property, interest, rents, royalties, dividends, alimony and separate maintenance payments, annuities, income from life insurance and endowment contracts, pensions, income from the discharge of indebtedness, distributive share of partnership gross income, income in respect of decedent, income from an interest in an estate or trust
Phaseout of personal and dependency exemptions
Exemptions are reduced by 2% for each $2,500 increment (or part increment) of AGI above the following threshold amounts—2016: Married filing jointly: $311,300 Single: $259,400
Residential energy-efficient property (REEP) credit
For tax years beginning after December 31, 2005 and before January 1, 2017, a tax credit is allowed for 3 types of energy efficient property installed on a taxpayer's principal residence: Solar hot water heaters Qualified solar electric property o Fuel cell property Residential wind property Geothermal heat pumps The credit is 30% of the cost of eligible property Taxpayer's basis in the property is reduced by the amount of the credit
Gross income test
Generally a dependent's gross income must be less than the amount of the dependency exemption Nontaxable scholarships, tax-exempt bond interest, and nontaxable Social Security benefits are not considered But salary, taxable interest, and rent are considered Gross income test is waived for a child of the taxpayer who is either under the age of 19, or, if a full-time student, under the age of 24 Dependent must be a child of the taxpayer
Deductions from AGI
Include any allowable deduction under itemized deductions or standard deduction, and personal and dependency exemptions
Non-business energy property credit
Individuals are allowed a nonrefundable tax credit for non-business energy property, such as residential windows and exterior doors, insulation, heat pumps, furnaces, central air conditioners, and water heaters Credit is limited to 10% of the cost, not to exceed a lifetime limit of $500 Applies to property placed into service after December 31, 2008 and before January 1, 2017
5 filing statuses
Married filing jointly Surviving spouse Head of household Single Married filing separately ** married filing jointly and surviving spouses use the same rate schedule
Married filing a separate return
Married individuals who choose to file separate returns must use the separate rate schedule—rates are higher than other individual rate schedules
List of itemized deductions
Medical expenses-- over 10% of AGI State, local, and foreign income and real property taxes State and local personal property taxes State and local sales taxes if an election is made to deduct these taxes instead of deducting state and local income taxes Residential interest and investment interest Charitable contributions Misc deductions-- over 2% of AGI 1) employee expenses-- professional and union dues, professional publications, travel, transportation, education, job hunting, home office, special clothing, and 50% of entertainment expenses 2) expenses for producing investment income-- accounting and legal fees, safe deposit rental, fees paid to an IRA custodian 3) tax advice and tax return preparation, and related costs Other misc deductions-- federal estate tax attributable to income in respect of decedent, gambling losses to the extent of winnings, amortization of bond premium, amounts restored under claim of right
Personal and dependency exemptions
Personal exemption is allowed for each taxpayer and his/her spouse Additional exemption is permitted for each dependent Amount is adjusted annually for increase in the cost of living-- $4050 in 2016
Child and dependent care credit
Provides relief for taxpayers who incur child and dependent care expenses because of employment activities To qualify for the credit, an individual must meet 2 requirements: 1) Child or dependent care expenses must be incurred to enable the taxpayer to be gainfully employed, and 2) The taxpayer must maintain a household for a dependent under the age of 13 or an incapacitated dependent or spouse Credit is 35% of the qualifying expenses-- ceiling limitation of $3000 for an individual and $6000 for a family Credit is reduced by 1% for each $2000 of adjusted gross income in excess of $15,000, but goes no lower than 20% An employee may exclude amounts up to $5000 from gross income for dependent care assistance payments made by an individual's employer and provided to the employee To avoid a double benefit, the otherwise eligible expenses for purposes of computing the child and dependent care credit are reduced by the amount of the assistance that is excluded from gross income
Tax credits
Reduce tax liability on a dollar-for-dollar basis-- tax deduction reduces taxable income and the value of the tax deduction is limited to the taxpayer's marginal tax rate
Self-employment tax
Self-employed individuals are responsible for paying both the employee and the employer contributions of Social Security and Medicare tax, in addition to income taxes Any self-employment net income in excess of $400 is subject to this tax The Social Security or old age and disability component (OASDI) of these taxes is 12.4% and for 2016 is capped on $118,500 of self-employment income-- 12.4% is composed of 6.2% for the employer portion and 6.2% for the employee portion The Medicare tax rate is 2.9% and is applied on the entire amount of self-employment income less an adjustment of 7.65%-- 1.45% for each the employee and employer portions IRC allows for 3 tax breaks for individuals required to pay SE taxes 1) the employer-paid portion of the self-employment taxes owed will be a deduction for AGI 2) 7.65% of the self-employment earnings are not subject to this tax 3) if applicable, any Social Security (OASDI) paid by the self-employed individual acting as an employee with unrelated W-2 wages, as well as the Social Security (OASDI) paid by the employer of those unrelated W-2 wages, will be taken into account when calculating self-employment taxes due For tax years after 2012, a new hospital insurance tax (Additional Medicare tax) of 0.9% applies to self-employment income of individuals whose earned income exceeds certain threshold amounts ** taxpayer's SE net earnings * .9235 plus W-2 wages are less than or equal to $118,500-- SE earnings * .9235 * .153 = SE taxes due, 50% of amount is a deduction for AGI ** taxpayer's SE net earnings * .9235 plus W-2 wages are greater than $118,500-- SE earnings * .9235 *.029 = Medicare tax (118,500 - W2 wages) * .124 = OASDI tax Add both steps for total SE tax due
Earned income credit
Similar to a welfare benefit for certain low-income families Based on earned income that includes wages, salaries, tips, and other employee compensation plus net earnings from self-employment and is designed to encourage low-income individuals to become gainfully employed Credit is available to individuals with qualifying children and to certain individuals without children if the earned income and AGI thresholds are met Applies to married individuals only if a joint return is filed Individuals without children are eligible only if the following requirements are met: 1) Individual's principal place of residence is in the U.S. for more than one-half of the tax year 2) Individual (or spouse if married) is at least age 25 and not more than age 64 at the end of the tax year 3) Individual is not a dependent of another taxpayer for the tax year
Dependency exemptions
Taxpayer may also claim a dependency exemption for each dependent in addition to a personal exemption for themselves To qualify as a dependent, an individual must meet the definition of either a qualifying child or a qualifying relative All dependents must: have a qualifying identification number, meet a citizenship test, meet a separate return test, not themselves claim another person as a dependent Additional requirements for qualifying children: relationship test, age test, abode test, support test Requirements for other relatives: relationship test, gross income test, support test
Itemized deductions
Taxpayers are allowed to itemize expenses related to: 1) The production or collection of income 2) The management of property held for the production of income, and 3) The determination, collection, or refund of any tax Claimed only if the total of such expenses exceeds the standard deduction
American Opportunity tax credit (AOTC)
Taxpayers are allowed up to a $2,500 credit for tuition and related expenses paid during the taxable year for each qualified student Qualified tuition and related expenses include only tuition and fees required for enrollment as well as course materials such as textbooks-- do not include room and board AOTC applies to EACH student for EACH child $2500 credit is allowed for a maximum of 4 years per student and is computed by taking 100% of the first $2000 of tuition and fees plus 25% of the second $2000 in tuition and fees Phaseout limitation for taxpayers filing joint returns for 2016 is $160,000 to $180,000
Kiddie tax
The tax on the net unearned income (dividends and interest) of a child under age 24 is calculated with reference to the parent's tax rate if it is higher than the child's Under kiddie tax rule, part of the net unearned income of the dependent child under age 24 is taxed at the child's tax rate and part at the parent's marginal tax rate if that rate is higher than the child's 3 different sets of rules are used to determine whether the kiddie tax applies: 1) Prior to the year a child turns 18, kiddie tax applies if the unearned income exceeds the $1,050 threshold 2) For the year the child turns 18, the kiddie tax applies if the child's earned income is less than or equal to one-half of his/her support and unearned income exceeds the $1,050 threshold 3) From that year that a child turns 19 up to and including the year the child turns 23, the kiddie tax applies only if a child is a full-time student, and the child's earned income is less than or equal to one-half of his/her support, and unearned income exceeds the $1,050 threshold Parents of a child subject to the kiddie tax may elect to include the child's dividend and interest income in their own return—eliminates the need to file a tax return for the child To be eligible for this election, the child's gross income must come solely from dividends and interest, and must not exceed $10,500
Relationship test
To be claimed as a dependent, a person must either be related to the taxpayer or reside with the taxpayer for the entire tax year Once established, an immediate family relationship is not terminated by death or divorce
Head of household
To claim head of household status, a taxpayer must meet the following conditions: 1) Be unmarried as of the last day of the tax year Exceptions apply to individuals married to nonresident aliens and to abandoned spouses Individual cannot claim head of household status in the year that his/her spouse died—must file a joint return or a separate return 2) Not be a surviving spouse 3) Be a U.S. citizen or resident 4) Pay over half the costs of maintaining his/her home as a household in which a dependent relative lives for more than half the tax year 2 special rules: 1) Taxpayer with a dependent parent qualifies even if the parent does not live with the taxpayer 2) An unmarried descendant who lives with the taxpayer need not be the taxpayer's dependent
Qualified retirement savings contributions credit (Saver's credit)
To encourage low and middle income taxpayers to save for retirement, a permanent, nonrefundable credit for contributions or deferrals to qualified retirement plans has been established for tax years beginning after December 1, 2001 The saver's credit is allowed in addition to otherwise allowable exclusions or deductions from gross income for retirement plan contributions or deferrals To be eligible, a taxpayer must be at least 18 years of age as of the close of the tax year, must not be claimed as a dependent on someone else's tax return, and must not be a full-time student as defined in Sec. 152(f)(2) for purposes of the dependency exemption Saver's credit is computed by multiplying the amount contributed (maximum $2000 per eligible individual per year) by an applicable percentage which depends on the taxpayer's AGI
Support test
To meet this test, you must have paid more than half of the person's living expenses for the year Living expenses include education, food, lodging, medical bills, dental care, vacations, clothes, books, and other items Scholarship received by a son/daughter is not counted as support in deciding whether a parent provided over one-half of the child's support A gift to be used exclusively by the dependent is included in support 2 exceptions to this general rule: A multiple support declaration permits one member of a group of taxpayers who collectively provide over 50% of an individual's support to claim the dependency exemption Special rules determine which parent will receive dependency exemptions for children in the case of a divorce Generally the parent who has custody of a child for the greater part of the year is entitled to the dependency exemption even if he/she did not provide over one-half of the child's support The non-custodial parent may claim the exemption only if the custodial parent agrees in writing—the signed statement must be attached to the non-custodial parent's return each year in which the exemption is claimed
Foreign credit
U.S. citizens, resident aliens, and U.S. corporations are subject to U.S. taxation on their worldwide income To reduce double taxation, the tax law provides a foreign tax credit for income taxes paid or accrued to a foreign country or a U.S. possession Taxpayers may elect to take a deduction for the taxes paid or accrued in lieu of a foreign tax credit—credit generally results in a greater tax benefit because a credit is fully offset against the tax liability whereas a deduction merely reduces taxable income
Net investment income
• Borrower's NII was needed in order to calculate how much the lender imputes as interest income in certain situations in which no interest was charged for a loan or an artificially low rate of interest was used Another reason for calculating NII is that Investment interest paid, such as interest paid to a broker in a margin account, is deductible in the current year only to the extent of NII Any investment interest incurred that exceeds the current year's NII would have to be carried over to the following year Net Investment Income is "Gross Investment Income" less the deductible "other investment related expenses" which are subject to the miscellaneous deduction threshold of 2% of AGI
Child tax credit
• Taxpayers are allowed a nonrefundable credit of $1000 for each qualifying child under the age of 17 Credit is phased out when the taxpayer's modified AGI reaches $110,000 at a rate of $50 for each $1000, or a fraction thereof, that modified AGI exceeds the above thresholds $75,000 for single taxpayers and $55,000 for married taxpayers filing separately A qualifying child must be a dependent of the taxpayer and must be the taxpayer's son or daughter or a descendent of either, a stepchild, or an eligible foster child-- child must also be a U.S. citizen, a U.S. national, or a resident of the U.S.
