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Title: Income Taxation of Individuals

Income TaxationofIndividuals
  • Chapter 11

Individual Income Tax Model
  • Gross income
  • Less Deductions for adjusted gross income
  • Equals Adjusted Gross Income (AGI)
  • Less Deductions from AGI (greater of
    itemized or standard deduction)
  • Less Exemptions (personal dependency)
  • Equals Taxable income

Tax Model (continued)
  • Taxable income
  • Times Tax rates
  • Equals Gross income tax liability
  • Less Tax credits
  • Plus Additions to tax
  • Less Tax prepayments
  • Equals Net tax due or tax refund

Deductions For AGI
  • Deductions discussed in previous chapters
  • Retirement plan contributions including IRAs
  • Moving expenses
  • 50 of self-employment taxes
  • Self-employed health insurance
  • Alimony paid

Deductions For AGI
  • Deductions discussed in this chapter
  • Educator expenses
  • Student loan interest expense
  • Tuition and fees deduction
  • Archer medical savings accounts (MSA)
  • Penalty on early withdrawals of savings

Educator Expenses
  • For kindergarten through 12th grade teachers
  • Deduct up to 250 of unreimbursed expenses
    teachers pay for books, supplies, computer
    equipment, software, and other supplemental
    materials used in the classroom
  • For tax years 2002 and 2003

Student Loan Interest
  • Deduction for interest paid on qualified student
    loans incurred and used for tuition, fees, room,
    board, books, and supplies
  • Deduction limit is 2,500
  • Phases out with modified AGI of 50,000 - 65,000
    (100,000 - 130,000 for married persons filing
  • Individuals claimed as dependents cannot take
    deduction on their own tax return
  • Eligible expenses must be reduced for tax-exempt
    scholarships and education credits

Tuition Fees Deduction
  • 3,000 deduction for 2002-2003 for tuition fees
    for taxpayer, spouse, and dependents
  • Individuals who are claimed as dependents cannot
    take deduction on their own tax return
  • No double benefit - no deduction if expense is
    deductible under any other provision (including
    education credits)
  • Income limits apply (65,000 if single and
    130,000 if married filing jointly)

Tuition Fees Deduction
  • For 2004 and 2005
  • Deduction increases to 4,000 for singles with
    income below 65,000 (130,000 if married filing
  • Deduction is 2,000 for singles with income
    65,000 - 80,000 (130,000 - 160,000 for joint

Archer Medical Savings Account
  • Taxpayers covered only by high-deductible medical
    insurance may deduct amounts set aside in MSA
  • Contributions and earnings on MSAs are not taxed
    when withdrawn to pay medical expenses
  • For 2003, qualified policies are those with
    deductibles of 1,700 - 2,500 for individuals
    (3,350 - 5,050 for families)
  • Contributions limited to 65 of policy deductible
    for individuals (75 for families)
  • Distributions not spent on qualifying expenses
    are included in income and subject to 15 penalty

Penalty on Early Withdrawals
  • Penalties assessed on premature withdrawals from
    certificates of deposits or other savings
    accounts are deductible
  • Gross interest income, unreduced by the penalty,
    is included in taxable income
  • Deducting the penalty ensures that only net
    interest income is included in taxable income

Filing Status
  • Taxpayers filing status determines standard
    deduction and tax rate schedule
  • Marital status determined on the last day of the
    tax year
  • Separated spouses are considered married until
    divorce becomes final

Filing Status - Married
  • Can file jointly if both spouses are US citizens
    or US residents (or if nonresident alien agrees
    to be taxed on worldwide income)
  • If the couple file separately, both must itemize
    deductions or both must use the standard deduction

Surviving Spouse
  • Marital status is determined at the date of death
    so a joint return can be filed for the year in
    which a spouse dies
  • A surviving spouse may continue to use the tax
    rates and standard deduction for married persons
    filing jointly for the next 2 years only if a
    dependent child lives with the taxpayer

Filing Status Unmarried
  • Unmarried taxpayers file as
  • Head of household - an unmarried person who
    provides more than half of the cost of
    maintaining a home in which a child or other
    qualifying relative lives for more than half the
  • Single

Head of Household
  • Qualifying relatives
  • Unmarried child who lives with the taxpayer for
    more than half of the taxable year (does not need
    to be taxpayers dependent)
  • A parent of the taxpayer who is a dependent (does
    not need to live in taxpayer's home)
  • Other qualifying relatives must live with the
    taxpayer for more than half the year and be a

Head of Household
  • Qualifying relatives include brothers, sisters,
    parents, grandparents, nieces, nephews, aunts and
    uncles (defined as brother or sister of father or
  • Cousins and more distant relatives are not
    included in the definition of qualifying relative

Abandoned Spouse
  • A taxpayer who is married but whose spouse did
    not live with him or her at any time during the
    last six months of the tax year and taxpayer
    provides more than half the cost of maintaining
    the home in which a dependent child lives
  • An abandoned spouse uses head of household tax
    rates and standard deduction

  • Each taxpayer (who is not a dependent) is
    entitled to one personal exemption
  • Exemption deduction is 3,050 for 2003
  • Additional exemptions allowed for each person who
    is considered a dependent
  • Anyone who is claimed as a dependent cannot claim
    a personal exemption

Dependency Exemptions
  • An individual qualifies as a dependent only if
    all 5 of the requirements are satisfied
  • 1. Relative or member-of-household test
  • 2. The support test
  • 3. Gross income test
  • 4. Joint return test
  • 5. Citizenship or residency test

Relative or Member-of-Household Test
  • The dependent must be either
  • Qualifying relative or
  • Member of taxpayer's household for the entire
    taxable year
  • Qualifying relatives include child, grandchild,
    brother, sister, parent, grandparent, niece,
    nephew, aunt, and uncle

The Support Test
  • Taxpayer must provide more than 50 of the
    dependent's total support
  • Support includes amounts spent for food,
    clothing, shelter, medical care, education and
    capital expenditures such as a car
  • Value of services and scholarship funds are
    omitted in determining support received by a
  • Nontaxable income used for support must be
    included in support determination

Multiple Support Agreement
  • Multiple support agreements allow one member of
    group of support providers to claim the exemption
  • Together the group meets the support test
  • All other dependency tests are met
  • Member who claims exemption must provide more
    than 10 of the total support

Gross Income Test
  • The dependent's gross income from taxable sources
    must be less than the exemption amount (3,050
    for 2003)
  • The gross income test is waived for
  • Child of taxpayer who is under age 19 at year end
  • Child of taxpayer who is under age 24 at year end
    and was a full-time student for at least 5 months
    during the year

Phaseout of Exemptions
  • Both personal and dependency exemptions are
    phased out at a rate of 2 (4 for MFS) for each
    2,500 (or fraction thereof) of AGI above
  • 139,500 if single
  • 174,400 if head of household
  • 209,250 if married filing jointly
  • 104,625 if married filing separately

Exemption Phaseout
  • (1) (AGI threshold AGI)/2,500 Phaseout
    Factor (always round up here)
  • (2) Phaseout Factor x 2 Phaseout Percentage
  • (3) Exemption Amount x (1 Phaseout Percentage)
    Adjusted Exemption Deduction
  • Once AGI exceeds the threshold AGI by more than
    122,500 (61,250 for MFS) the exemption
    deduction is completely phased out

2003 Tax Act Changes
  • Standard deduction marriage penalty relief
  • For 2003 and 2004 married filing jointly
    deduction increases to double the deduction for
    single individuals (increases from 7,950 to
    9,500 for 2003)
  • Married filing separately use single amount
  • After 2004 returns to present law

Standard Deductions
  • Standard Deductions (after 2003 Tax Act)
  • 9,500 married filing a joint return
  • 4,750 married filing separately
  • 7,000 head of household
  • 4,750 single individual
  • Add on to standard deduction if taxpayer elderly
    (age 65) or blind
  • 1,150 if single or head of household
  • 950 if married

Standard Deduction
  • Dependents standard deduction limited to greater
  • (1) 750 or
  • (2) Earned income 250 (up to otherwise
    allowable standard deduction)
  • Earned income includes salary and wages
  • Earned income does not include interest income,
    dividend income, capital gains, or income as
    beneficiary of a trust

Itemized Deductions
  • Itemized deductions provide tax benefit only to
    the extent that, in total, they exceed the
    taxpayers standard deduction
  • Taxpayers can maximize use of the standard
    deduction and itemized deductions by timing
    certain deductible payments

Medical Expenses
  • Medical expenses paid for the taxpayer, spouse
    and dependents, after reduction for insurance
    reimbursements, are deductible only to the extent
    they exceed 7.5 of AGI for the year
  • Qualified medical costs includes prescription
    drugs and insulin, costs of a hospital, clinic,
    doctor, dentist, eyeglasses, contract lenses,
    transportation for medical care and medical
    insurance costs

Medical Expenses
  • Health insurance premiums for taxpayers and their
    dependents are deductible only if paid from
    after-tax income
  • Premiums paid through an employer-sponsored
    cafeteria plan are not deductible
  • Premiums for disability insurance and for loss of
    life, limb or income are not deductible
  • Premiums for long-term care insurance are
    deductible subject to limits based on age

  • Deductible taxes include
  • State, local, and foreign real property taxes
  • State and local personal property taxes
  • State, local, and foreign income taxes
  • Other federal, state, local, and foreign taxes
    incurred in a business or other income-producing

Nondeductible Taxes
  • Federal income taxes
  • Employee's share of payroll taxes
  • Federal excise taxes not incurred for business
  • State and local sales taxes on goods for personal
  • Assessments on property

Interest Expense
  • Deductible interest includes
  • Student loan interest (deductible for AGI)
  • Investment interest
  • Home mortgage interest
  • No deduction for most other personal interest
    such as interest on auto loans, life insurance
    loans, credit card debt, and delinquent tax

Investment Interest Expense
  • Investment interest includes interest on loans to
    acquire or hold investment property and margin
    interest paid to a broker
  • Investment interest expense is only deductible to
    the extent of net investment income
  • Net investment income excess of investment
    income over investment expenses
  • Excess is carried forward (indefinitely) subject
    to same limit in future years

Investment Interest Expense
  • Investment income gross income from interest,
    annuities, and short-term capital gains from
    investment property
  • Long-term capital gains or dividends taxed at
    favorable rates are excluded unless election made
    to forgo the favorable rate
  • Investment expenses safe deposit box rental
    fees, investment counsel fees, brokerage account
    maintenance fees
  • Use lesser of total investment expenses or net
    miscellaneous itemized deductions after reduction
    for 2 AGI floor

Qualified Residence Interest
  • Interest paid for acquisition debt or home equity
    debt for up to 2 qualified residences
  • Interest on acquisition debt of up to 1 million
    principal (combined limit for 2 homes) is
  • Acquisition debt includes mortgage to buy,
    construct, or improve the residence

Qualified Residence Interest
  • Interest on up to 100,000 principal amount of
    home equity loan is deductible
  • Loan proceeds can be spent for anything
  • Points (loan origination fees) paid on home
    mortgages are deductible
  • Points paid on refinancing must be amortized over
    life of loan

Charitable Contributions
  • Congress allows individuals, corporations,
    estates and trusts deductions for charitable
    contributions to certain qualified organizations
  • Partnerships and S corporations pass the
    contributions through to their partners and
    shareholders who claim the deductions on their
    own income tax returns

Charitable Contributions
  • Qualified charitable organizations
  • Governmental units (federal, state and local
    governments) and entities formed and operated
    exclusively for religious, charitable,
    scientific, literary or educational purposes,
    including churches, nonprofit hospitals, school
    and universities, libraries, and social service
  • Direct contributions to needy individuals are not

Charitable Contributions
  • No deduction allowed to the extent that valuable
    goods or services are received in return for the
  • Exception - contributors to universities who
    receive preferred rights to purchase tickets for
    university athletic events may deduct 80 of the
    amount of their contribution
  • Individuals can deduct up to 50 of AGI
  • Excess contributions carry forward up to 5 years

Charitable Contributions
  • No deduction for contributions of the taxpayers
    services and rent-free use of the taxpayers
  • Out-of-pocket costs incurred related to volunteer
    work are deductible
  • Property other than long-term capital gain
    property is valued at lesser of FMV or basis

LTCG Property Contributions
  • LTCG property is valued at the higher FMV
  • Tangible personalty given to a charity which does
    not use the property in its tax-exempt activity
    is valued at the lower adjusted basis
  • LTCG property valued at FMV limited to 30 AGI
  • 30 limit can be avoided (then 50 AGI limit
    applies) if taxpayer elects to use lower basis
  • If made, election applies to all LTCG
    contributions that year

Charitable Contributions
  • Stocks that have declined in value should be sold
    so that the loss can be claimed with the proceeds
  • Fees incurred for appraisals of donated property
    may be deducted as miscellaneous itemized

Casualty and Theft Losses
  • Loss is the lesser of
  • Assets adjusted basis or
  • Decline in assets fair market value from the
  • Loss is reduced for any insurance proceeds
  • 100 floor applies to each casualty
  • Deductible only to extent total losses exceed 10
    of AGI

Miscellaneous Deductions
  • Only excess over 2 AGI is deductible
  • Unreimbursed employee business expenses
  • Job hunting expenses (in searching for a new job
    in current line of business)
  • Investment-related expenses
  • Hobby expenses (up to hobby income)
  • Tax preparation and planning advice

Phaseout ofItemized Deductions
  • Total deductions phased out by 3 of AGI in
    excess of 139,500 in 2003 (69,750 if MFS)
  • Exception - deductions not phased out for
  • Medical expenses
  • Investment interest
  • Casualty and theft losses
  • Total deductions are not reduced by more than 80
    regardless of type

2003 Tax Act Changes
  • Individual income tax rates above 15 drop to
    25, 28, 33, and 35
  • The 10 bracket expands
  • For 2003 and 2004 to the first 7,000 of taxable
    income for single individuals and married filing
    separately (14,000 for married filing joint
  • 15 bracket expands to relieve marriage tax

2003 Tax Act New Rates
  • For married filing joint return for 2003
  • 10 on first 14,000 taxable income
  • 15 on 14,001 - 56,800
  • 25 on 56,801 - 114,650
  • 28 on 114,651 - 174,700
  • 33 on 174,701 - 311,950
  • 35 over 311,950

2003 Tax Act New Rates
  • For married filing separately for 2003
  • 10 on first 7,000 taxable income
  • 15 on 7,001 - 28,400
  • 25 on 28,401 - 57,325
  • 28 on 57,326 - 87,350
  • 33 on 87,351 - 155,975
  • 35 over 155,975

2003 Tax Act New Rates
  • For single individuals for 2003
  • 10 on first 7,000 taxable income
  • 15 on 7,001 - 28,400
  • 25 on 28,401 - 68,800
  • 28 on 68,801 - 143,500
  • 33 on 143,501 - 311,950
  • 35 over 311,950

2003 Tax Act New Rates
  • For head of household for 2003
  • 10 on first 10,000 taxable income
  • 15 on 10,001 - 38,050
  • 25 on 38,051 - 98,250
  • 28 on 98,251 - 159,100
  • 33 on 159,101 - 311,950
  • 35 over 311,950

Special Tax Rates
  • 28 rate applies to LTCG from collectibles and
    Section 1202 small business stock
  • 25 rate applies to unrecaptured Section 1250
  • For capital assets sold or exchanged after May 5,
    2003 new rates apply
  • 15 rate (instead of 20)
  • 5 rate applies to taxpayers in 10 or 15 tax
  • Dividend income will be taxed using the new 15
    rate (5 for low-income taxpayers)

Credits vs. Deductions
  • Credits are direct dollar-for-dollar reductions
    in the gross tax liability
  • Tax credits have the same dollar value to all
    taxpayers, regardless of their marginal tax

Child Tax Credit
  • 2003 Tax Act increased to 1,000 (from 600)
    nonrefundable tax credit for each qualifying
    child under age 17
  • Qualifying children include the taxpayers son,
    daughter, stepson, stepdaughter, grandchild, or
    eligible foster child that the taxpayer claims as
    a dependent
  • Phased out at rate of 50 for every 1,000 (or
    part thereof) of AGI in excess of
  • 110,000 if married filing jointly (55,000 if
  • 75,000 if single or head of household

Education Credits
  • Two elective nonrefundable tax credits are
    provided for college or vocational tuition and
    fees for the taxpayer, spouse, or dependents
  • Hope Scholarship Credit 100 of first 1,000
    and 50 of second 1,000 tuition and fees for
    first 2 years only (maximum 1,500 per student)
  • Lifetime Learning Credit 20 of up to 10,000
    tuition and fees (maximum 2,000 per taxpayer in
  • A student who is a dependent cannot claim the

Education Credits
  • Expenses paid with a Pell Grant, scholarship, or
    employer-provided educational assistance do not
  • The election is separate for each student, so a
    parent may choose one credit for one child and a
    different credit for a second child
  • Both credits phase out over modified AGI of
  • 41,000 - 51,000 if single
  • 83,000 - 103,000 if married filing jointly

Earned Income Credit
  • To reduce the impact of payroll taxes for
    low-income individuals
  • Credit is equal to a percentage of earned income
    below a maximum
  • With one qualifying child maximum credit is
    2,547 (7,490 x 34)
  • With two or more qualifying children maximum
    credit is 4,204 (10,510 x 40)
  • Smaller credit available to taxpayers without
    children of 382 maximum (4,990 x 7.65)

Earned Income Credit
  • This is a refundable credit
  • Taxpayers with investment income of 2,600 or
    more are not eligible
  • Anyone who can be claimed as a dependent is not
  • Must be a working taxpayer age 25 through 64

Dependent Care Credit
  • Nonrefundable credit for taxpayers who pay for
    child or dependent care so they can work
  • Credit percentage varies from 20 to 35 of up to
    4,000 for one qualifying child or 6,000 for 2
    or more qualifying children
  • 35 for AGI not exceeding 15,000
  • Reduced by 1 for each 2,000 (or fraction
    thereof) AGI exceeds 15,000
  • 20 for AGI exceeding 43,000

Retirement Contributions Credit
  • To encourage participation by low-income wage
    earners credit for up to 2,000 contributed to
    employer plans or IRAs
  • Credit varies with AGI
  • 50 credit for joint filers with AGI up to
    30,000 (15,000 if single)
  • 20 for joint filers with AGI of 30,000 -
    32,500 (15,000 - 16,250 if single)
  • 10 for joint filers with AGI of 32,500 -
    50,000 (16,250 - 25,000 if single)
  • Dependents or full-time students are not eligible

Excess Payroll Tax Credit
  • Taxpayers working for more than one employer
    during the year with earnings exceeding the
    Social Security ceiling (87,000 for 2003)
    usually have too much tax withheld
  • Employee is allowed a credit for any excess
    Social Security taxes withheld

Alternative Minimum Tax
  • An alternative tax to ensure high-income
    taxpayers pay their fair share of tax
  • Certain deductions are disallowed or reduced and
    certain exempt income items are subject to the
  • IF AMT is greater than the regular tax, taxpayers
    pay the larger amount
  • Rate is 26 on first 175,000 and 28 on excess

AMT Model
  • Taxable income
  • Plus/minus Adjustments to taxable income
  • Plus Tax preferences
  • Less Allowable exemptions
  • Equals Alternative minimum taxable income
  • Times AMT tax rates
  • Plus Tentative minimum tax (TMT)
  • Less Regular income tax
  • Equals AMT

AMT Exemptions
  • 2003 Tax Act increased AMT exemptions for 2003
    and 2004 to
  • 58,000 if married filing jointly (was 49,000)
  • 29,000 if married filing separately (was
  • 40,250 if single or head of household (was
  • Exemptions begin to phase out when AMTI reaches
    112,500 for singles and 150,000 for married
    filing jointly (75,000 if MFS)

Alternative Minimum Tax
  • Itemized deductions are different from those
    calculated for regular income tax
  • Medical expenses must exceed 10 AGI
  • Taxes, home equity loan interest, and
    miscellaneous itemized deductions are not
  • Tax preferences that are added include
  • Nontaxable interest on private activity bonds
  • Bargain element of incentive stock options

Payment of Income Tax
  • Estimated quarterly payments are made by persons
    with large amounts of income from sources not
    subject to withholding
  • Due on April 15, June 15, September 15 of current
    year and January 15 of following year
  • If the tax paid by April 15 is not at least 90
    of the total tax owed, a penalty may be charged
    (unless balance due is less than 1,000)

Filing Requirements
  • Any taxpayer whose gross income is less than the
    sum of their standard deduction and their
    personal exemption (but not dependency
    exemptions) does not have to file a tax return
  • 7,800 in 2003 for a single individual
  • Returns should be filed if
  • Self-employed with 400 of net SE earnings
  • Children with unearned income over 750
  • Married filing separately if income over 3,050

The End