Chapter 3

Individual TaxationAn Overview

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Chapter 3 Exhibits

1. Federal Tax Formula2. Gross Income3. Examples of “For” AGI Deductions4. Personal and Dependency Exemptions5. Dependency Exemptions—Qualifying Child6. Dependency Exemptions—Qualifying Relative7. Dependency Exemptions—Married Dependents8. Dependency Exemptions—Multiple Support Agreement9. Dependency Exemptions—Divorced Parents—Post 1984

Chapter 3, Exhibit Contents A

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Chapter 3 Exhibits

10. Itemizing v. Standard Deduction11. Examples of Itemized Deductions (Deductions “From” Adjusted Gross Income)12. Additional Examples of Itemized Deductions13. Standard Deduction Filing Status14. Additional Standard Deduction15. Criteria for Abandoned Spouse16. Criteria for Surviving Spouse17. Criteria for Head of Household

Chapter 3, Exhibit Contents B

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Chapter 3 Exhibits

18. Tax Returns of Dependents19. Tax Returns of Dependents—The Kiddie Tax20. Kiddie Tax21. Self-Employment Tax22. Filing Requirements 23. Tax Tables v. Tax Rate Schedule

Chapter 3, Exhibit Contents C

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Federal Tax Formula

Gross Income

– Deductions FOR Adjusted Gross Income

= Adjusted Gross Income

– Greater of

Standard Deduction OR Itemized Deductions

– Personal Exemptions

= Taxable Income

Step 1: Compute taxable income

Chapter 3, Exhibit 1a

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Federal Tax Formula

Taxable Income

x Tax Rate

= Tax Liability (Total Tax)

– Tax Credits and Prepayments

+ Alternative Minimum Tax (if any)

+ Employment Taxes (if any)

= Net Tax Due or Refund

Step 2: Compute tax due (or refund)

Chapter 3, Exhibit 1b

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Gross Income

Gross income includes all items of income from whatever source unless specifically excluded.

Examples of gross income include wages, salaries, tips, interest, dividends, alimony received, business income, rental income, royalties, pensions, and annuities.

Chapter 3, Exhibit 2

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Examples of “For” AGI Deductions

Trade or business expenses Student loan interest One-half of self-employment tax Alimony payments Certain moving expenses IRA deductions 100% of medical and insurance premiums for self-

employed taxpayers, their spouses, and dependents

Chapter 3, Exhibit 3

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Personal and Dependency Exemptions

In computing taxable income, an individual is allowed a deduction for each personal exemption allowed.

An exemption is allowed for each of the following:

(1) Individual taxpayer and spouse.

(2) Dependents of the taxpayer- qualifying child or - qualifying relative

Chapter 3, Exhibit 4a

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The deduction amount is $3,800 per exemption allowed for 2012.

Example: Bob and Donna Jones are married and filed a joint return. They have 3 dependent children. For 2012, their total exemption is $19,000 ($3,800 x 5 exemptions).

Personal and Dependency Exemptions

Chapter 3, Exhibit 4b

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Dependency Exemptions—Qualifying Child

Taxpayers are allowed to take an exemption for each qualifying child. Must meet 4 tests.

R – Relationship

A – Age

S – Support

H – Housing

Chapter 3, Exhibit 5a

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Dependency Exemptions—Qualifying Child

Relationship – child, stepchild, sibling (or a descendent of any of these individuals).

Age – under 19 or under 24 and full time student.

Support – a child who provides over ½ of its own support is not a qualifying child.

Housing – child lived with the taxpayer for over ½ the year.

Chapter 3, Exhibit 5b

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A taxpayer is allowed an exemption for each qualifying relative. The potential dependent must meet 4 tests.

1. Relationship/Household Test

Either of the following must be satisfied. 

1) Relationship test: Dependent must be a relative. Aunts and uncles qualify, first cousins do not.

2) Household test: Dependent must occupy the taxpayer’s household during the entire year (exceptions include birth, death, illness, education, military and business travel).

Dependency Exemptions—Qualifying Relative

Chapter 3, Exhibit 6a

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2. Gross Income Test

Dependent’s gross income < $3,800 in 2012.

3. Support Test

A taxpayer must provide over one-half of the amount “actually spent” on support for the potential dependent. Includes food, shelter, clothing, medical care and education. Scholarships are not counted in determining the support of a potential dependent.

4. Not a qualifying child

Chapter 3, Exhibit 6b

Dependency Exemptions—Qualifying Relative

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Dependency Exemptions—Married Dependents

An individual (such as a parent) may not claim an exemption for a dependent who filed a joint return with the dependent’s spouse unless:

The dependent and the dependent’s spouse are only filing a return to receive a refund and no tax liability would exist for either spouse on separate returns.

Chapter 3, Exhibit 7

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Dependency Exemptions—Multiple Support Agreement

A taxpayer is considered as having provided over half the support of an individual where 2 or more people contributed support if the following 4 tests are met.

1) No one person contributed over half the support.

2) Those who collectively furnished over ½ the support could have claimed the exemption except for the support test.

Chapter 3, Exhibit 8a

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3) The taxpayer claiming the exemption paid over 10% of the support and

4) Each person who paid over 10% files a written declaration that they will not claim the individual as a dependent.

Chapter 3, Exhibit 8b

Dependency Exemptions—Multiple Support Agreement

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Dependency ExemptionsDivorced Parents—Post 1984

The general rule is that the custodial parent is entitled to the exemption in all cases UNLESS the following is met:

The custodial parent files a written declaration waiving the right to the exemptions

Chapter 3, Exhibit 9

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Itemizing v. Standard Deduction

All taxpayers receive a minimum deduction called the standard deduction. The standard deduction is based on your filing status.

Some taxpayers may have expenses that qualify as itemized deductions. Itemized deductions are expenses of a personal nature that are specifically allowed as a deduction.

Chapter 3, Exhibit 10a

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(You can take one, but not both.)

1. Figure out your standard deduction. (Add your basic standard deduction plus any additional standard deductions for age and/or blindness or additional standard deductions for property taxes and federally declared disasters).

2. Add up all itemized deductions. Also called deductionsFROM adjusted gross income.

3. Subtract the larger of your itemized deductionsOR your standard deduction.

Chapter 3, Exhibit 10b

Itemizing v. Standard Deduction

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Examples of Itemized Deductions(Deductions “From” Adjusted Gross Income)

Medical expenses exceeding 7.5% AGI floor not business related

Property taxes state and local, not federal on principal residences, personal-use cars, stock, and other non

business-use property

Chapter 3, Exhibit 11

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Additional Examples of Itemized Deductions Income taxes

state and local, not federal on salaries, capital gains, and other non-business income

Interest on home mortgages (including home equity loans) Casualty losses

exceeding 10% AGI floor on principal residences, personal-use cars, and other personal-

use property Charitable contributions

not to exceed 50% AGI ceiling in certain cases, not to exceed 30% or 20% ceiling

Chapter 3, Exhibit 12a

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Most miscellaneous itemized deductions but only the aggregate amount exceeding 2% AGI floor

Examples:

  unreimbursed employee business expenses

  hobby expenses (out-of-pocket and depreciation)

  tax preparation fees

  investment counseling fees

Exception:

  gambling losses are NOT subject to the 2% AGI floor

Chapter 3, Exhibit 12b

Additional Examples of Itemized Deductions

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Standard DeductionFiling Status

$5,950 Single individuals $11,900 Married individuals filing jointly $5,950 Married individuals filing separate returns $8,700 Heads of households (and abandoned spouse) $11,900 Surviving spouses

Remember, you have to know your filing status in order to determine the amount of your standard deduction.

Chapter 3, Exhibit 13

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Additional Standard Deduction

An addition standard deduction is allowed for aged (65 and older) or blind taxpayers.

The additional standard deduction is $1,450 for unmarried taxpayers ($1,150 for married taxpayers).

Example: Mr. and Mrs. Smith are both over the age of 65. If their filing status is married filing jointly, they will be allowed a total standard deduction of $14,200. They are allowed a basic standard deduction of $11,900 plus a $2,300 additional standard deduction ($1,150 x 2) because they are both over 65.

Chapter 3, Exhibit 14

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Criteria for Abandoned Spouse

1. Cost of household furnished by taxpayer exceeds one-half of the total cost.

2. Abode of the taxpayer is the abode of a dependent child over one-half of the year.

3. Other spouse not member of household during last half of year.

4. Separate return is filed.

Chapter 3, Exhibit 15

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1. Taxpayer must be unmarried.

2. Taxpayer must furnish more than one-half of the cost of household

for a child or stepchild.

3. Child or stepchild must be a dependent. No other relatives qualify.

4. Taxpayer's household must be the principal abode for a child or

stepchild for more than one-half the year.

Chapter 3, Exhibit 16

Criteria for Surviving Spouse

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Criteria for Head of Household

1. Taxpayer must be unmarried.

2. Taxpayer must furnish more than one-half the cost of the household for a dependent.

3. Unmarried qualifying child need not be a dependent.

Other relatives (including married child or grandchild or unmarried foster child) must be dependents. Dependency through a multiple support agreement does not count.

4. Taxpayer’s household must be the principal abode for more than one-half of the year. However, the taxpayer’s dependent parents do NOT need to live with the taxpayer.

Chapter 3, Exhibit 17

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Tax Returns of Dependents

An individual cannot take a personal exemption for themselves if they can be claimed as a dependent on another persons return.

An individual is entitled to a standard deduction equal to the greater of:

1. $950 or

2. The taxpayers earned income plus $300 (up to themaximum standard deduction of $5,950 for 2012).

Chapter 3, Exhibit 18

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The Kiddie Tax

The general rule is that if a dependent child under age 18 has net unearned income in excess of $1,900 the excess (over $1,900) is taxed at the parents’ top rate.

Net unearned income is investment income (income from interest, dividends, capital gains and trusts)

Chapter 3, Exhibit 19

Tax Returns of Dependents

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Kiddie Tax

Step 1: Determine the child’s taxable income

Gross Income (earned and unearned income)

Less standard deduction for a dependent

(the greater of $950 or earned income plus $300)

= Child’s taxable income

Chapter 3, Exhibit 20a

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Step 2: Determine how much of the child’s unearned income is taxed at the parents’ top rate

Unearned Income

- Less $950 (called the first $950)

- Less the greater of (1) $950 or (2) total allowable deductions associated withthe production of the unearned income

= Unearned income taxed at the parents’ top rate

Chapter 3, Exhibit 20b

Kiddie Tax

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Kiddie Tax

Step 3: Determine how much income is taxed at the child’s rate

Taxable Income from Step 1

Less Unearned income taxed at the parents’ rate from Step 2

= Income taxed at the child’s rate

Chapter 3, Exhibit 20c

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Self-Employment Tax

For 2012, the tax rate is 13.3%, made up of two parts:

1) An old-age, survivors, and disability insurance (OASDI) rate of 10.4% (6.2% of the employer and 6.2% of the employee) on self-employment income up to $110,100.

2) A medicare hospital insurance (HI) rate of 2.9% without limit on self-employment income.

Chapter 3, Exhibit 21a

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1) Net self-employment income * .9235

= Net income from self-employment

2) Net income from self-employment * 13.3%

= Self-employment tax

**The employer portion of the self-employment tax is allowed as a deduction for AGI

Chapter 3, Exhibit 21b

Self-Employment Tax

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Filing Requirements

General rule is that if gross income exceeds the standard deduction plus personal exemptions, the taxpayer must file a return. There are exceptions to this rule.

The additional standard deduction for age is added to the basic standard deduction, however the additional standard deduction for blindness is not.

A return must be filed if an individual had more than $400 in earnings from self-employment.

Chapter 3, Exhibit 22

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Tax Tables v. Tax Rate Schedule

Taxpayers with less than $100,000 of taxable income should use the tax tables.

Taxpayers that cannot use the tax tables should use the tax rate schedule (see inside front cover of textbook).

Chapter 3, Exhibit 23