Tax Chapter 3 Notes.doc

19 Pages
Unlock Document

Ohio State University
Accounting and Management Info
Alan Lacko

CHAPTER 3 TAX FORMULA AND TAX DETERMINATION; AN OVERVIEW OF PROPERTY TRANSACTIONS LECTURE NOTES TAX FORMULA COMPONENTS OF THE TAX FORMULA 1. The following formula is used to compute taxable income for individual taxpayers (see Figure 3.1 in the text): Income (broadly conceived) $xx,xxx Less: Exclusions (x,xxx) Gross income $xx,xxx Less: Deductions for adjusted gross income (AGI) (x,xxx) Adjusted Gross Income $xx,xxx Less: The greater of – Total itemized deductions or standard deduction (x,xxx) Less: Personal and dependency exemptions (x,xxx) Taxable income $xx,xxx Tax on taxable income $ x,xxx Less: Tax credits (xxx) Tax due (or refund) xxx a. Computation of tax. Once taxable income has been computed, the additional tax due to the government or the refund due to the taxpayer can be computed. Tax on taxable income (from Tax Table or Tax Rate Schedules) – Credits and prepayments = Amount owed (or refund due) b. Most individuals use the Tax Table for computation of the tax. 3-1 3-2 2014 Individual Edition/Instructor’s Guide with Lecture Notes 2. Income (broadly conceived). This includes all income of the taxpayer, both taxable and nontaxable. a. This concept of income is essentially equivalent to gross receipts, but does not include a return of capital or a receipt of borrowed funds. b. Many receipts (e.g., borrowed funds) are not reported on the tax return at all. 3. Exclusions. Congress has chosen to allow taxpayers to exclude certain items of income for various reasons (see Chapters 4 and 5 for details). Some examples are listed below. See Exhibit 3.1 in the text (Partial List of Exclusions from Gross Income) for other examples. Accident insurance proceeds Child support payments Gifts Inheritances Life insurance paid on death of insured Welfare payments Unemployment compensation (to a limited extent) 4. Gross Income. Section 61(a) of the Code defines gross income broadly as “all income from whatever source derived.” Some examples of gross income items are listed below. See Exhibit 3.2 in the text (Partial List of Gross Income Items) for other examples. Alimony Compensation for services Dividends Embezzled funds Gains from illegal activities Prizes Salaries Tips and gratuities 5. Deductions for Adjusted Gross Income. Included are trade or business expenses, reimbursed employee business expenses, one-half of self-employment tax paid, alimony paid, traditional IRA and Keogh contributions, forfeited interest penalty, moving expenses, capital losses, qualified interest on education loans, and other items. a. Deductions for AGI are deductible whether the taxpayer itemizes or not, while itemized deductions will benefit the taxpayer only if total itemized deductions exceed the standard deduction. CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-3 b. Deductions for AGI are also designated as “above-the-line” deductions. This reflects that the deductions are claimed before (“above-”) AGI (“-the-line”) is reached. They are also referred to as “page 1 expenses” since they are reported on page 1 of Form 1040. 6. Adjusted Gross Income. This is an important subtotal applicable to individual taxpayers, but not to corporations. It is commonly used to limit itemized deductions. Floors and ceilings are stated as a percentage of AGI. a. Floor. Casualty losses are deductible only to the extent they exceed 10% of AGI. Other examples include: (1) Medical expenses are deductible only to the extent they exceed 10% of AGI (7.5% in 2012 and prior years). See Example 4 in the text. (2) Some miscellaneous itemized deductions are deductible only if they exceed 2% of AGI. See chapters 9 and 10. b. Ceiling. The deduction for charitable contributions may not exceed 50% of AGI. c. AGI is the last line of page 1 and the first line of page 2 of Form 1040. 7. Itemized Deductions. Included are medical expenses, various (but not all) state, local, and foreign taxes, home mortgage interest, investment interest, charitable contributions, and miscellaneous expenses. a. A taxpayer should elect to itemize only if itemized deductions exceed the standard deduction (see item 14. below). b. Itemized deductions are reported on Schedule A of Form 1040. c. See Exhibit 3.3 in the text (Partial List of Itemized Deductions) for additional examples. d. Whether an expense is a deduction for or deduction from AGI may depend upon the circumstances involved. (1) Alicia pays interest on a loan obtained to purchase inventory for her furniture store. The interest is a deduction for AGI. (2) Alicia pays interest on her home mortgage. The interest is a deduction from AGI (i.e., itemized deduction). 3-4 2014 Individual Edition/Instructor’s Guide with Lecture Notes 8. Review the list of nondeductible expenditures appearing on pp. 3-7 and 3-8 of the text. a. Because they have no tax effect, these expenditures are not mentioned as a component of the tax formula. Also, they are not reported on tax returns (e.g., Form 1040). b. If an item is nondeductible, it does not matter how the related activity is classified. Thus, a speeding ticket is nondeductible whether the auto was being used on a business trip (deduction for AGI) or on a visit to a dentist (deduction from AGI). 9. Correlation of Tax Formula with Tax Form. a. At the beginning of each chapter, the text highlights the component of the tax formula to be discussed. b. The tax framework is tied to the portion of the tax return affected. (a) The tax return correlation only involves Form 1040 (i.e., “the long-form”). Forms 1040A and 1040EZ are not included. (b) Correlation is limited to pages 1 and 2 of Form 1040—references to supporting schedules (e.g., Form 2106, Schedule C) generally are not included. STANDARD DEDUCTION 10. In general. a. The standard deduction is a component of the Tax Formula —see Figure 3.1. (1) Taxpayers must choose between the standard deduction and itemizing. (2) Reason for the standard deduction—see p. 3-9 and footnote 6. b. There are two types of standard deduction: basic and additional. (1) Certain individuals are not eligible. (2) Special provisions apply in determining the standard deduction available to dependents. 11. Basic Standard Deduction. The standard deduction exempts a specified amount of income from tax. The allowable standard deduction is based on the taxpayer’s filing status (see Table 3.1 in the text). 12. Additional Standard Deduction. This is an additional amount allowed for taxpayers who are age 65 or older and/or blind. CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-5 a. The additional standard deduction for 2013 is $1,200 for married taxpayers and $1,500 for taxpayers who are not married (see Table 3.2 in the text). Example: Ted, a single taxpayer who is age 66 and blind, is allowed an additional standard deduction of $3,000 ($1,500 X 2). b. The additional standard deduction is allowed for the taxpayer and/or spouse. However, a taxpayer cannot claim an additional standard deduction for age or blindness of dependents. 13. Total Standard Deduction. This is equal to the regular and additional standard deductions. Compare the taxpayer’s total standard deduction to itemized deductions to determine whether the taxpayer should itemize. 14. Standard Deduction Not Allowed. The standard deduction may not be claimed by the following: a married individual filing separately if either spouse itemizes; a nonresident alien; or an individual filing a short-period return due to a change in accounting period. Example: Joe and Lynn are married and file separate returns in 2013. Joe claims itemized deductions of $7,600 on his return. Lynn has itemized deductions of $1,500. Lynn must itemize and deduct $1,500, even though the standard deduction for a married person filing separately normallywould be $6,100. ETHICS & EQUITY Same-Sex Marriage and the Standard Deduction (page 3-10). Unlike the case of Joe and Lynn (see the Example under item 15.), a completely different result occurs. Because the IRS adheres to DOMA (Defense of Marriage Act), it recognizes a marriage only if it is between a man and a woman. Thus, Jim and Beau are not married for Federal income tax purposes. As single taxpayers filing individual returns, therefore, each can make his own choice in terms of itemizing or claiming the standard deduction. Neither is bound by what the other does! 3-6 2014 Individual Edition/Instructor’s Guide with Lecture Notes 15. Standard Deduction of a Dependent. In 2013, the standard deduction for an individual claimed as a dependent of another taxpayer is limited to the greater of $1,000 or the individual’s earned income + $350 (but not to exceed the amount of the basic standard deduction for the taxpayer’s filing status). Example: Tina, an unmarried dependent child, earns $400 on a summer job. Her standard deduction is $1,000 [the greater of earned income ($400) + $350 or $1,000 standard deduction]. Example: Ken, an unmarried dependent child, earns $1,400 on a summer job. His standard deduction is $1,750 [the greater of earned income ($1,400) + $350 or $1,000 standard deduction]. Example: Beth, an unmarried dependent child, earns $6,000 on a summer job. Her standard deduction is $6,100 [the greater of earned income $6,000 + $350) or $1,000 standard deduction, but limited to the $6,100 maximumstandard deduction]. 16. Rationale: The standard deduction of a dependent is limited to negate the ability of taxpayers to shift unearned income and shelter it through use of the standard deduction. PERSONAL EXEMPTIONS 17. Exemption Amount. The exemption amount is $3,900 in 2013 ($3,800 in 2012). The amount is indexed (adjusted for inflation) each year. 18. Personal Exemption – Who Qualifies. A personal exemption is generally allowed for the taxpayer (and the taxpayer’s spouse if a joint return is filed). a. If a separate return is filed, an exemption is allowed for a spouse only if the spouse had no gross income and was not claimed as a dependent by another taxpayer. b. For Federal tax purposes, the law does not recognize same-sex marriages. DEPENDENCY EXEMPTIONS 19. A dependent has to be either a qualifying child or a qualifying relative. a. For a comparison of the tests applicable to each category, refer to Concept Summary 3–1 in the text. b. Note that both categories require the satisfaction of the joint return test and the citizenship test. CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-7 Qualifying Child 20. A qualifying child must satisfysix tests: • Support. • Relationship. • Abode. • Age. • Joint return. • Citizenship or residency. In some situations, a child may be a qualifying child to more than one person. The tax law specifies which person has priority (see Table 3.3 in the text). 21. Support test. The child must not be self-supporting. 22. Relationship test. a. The relationship test includes a taxpayer’s child (son, daughter), adopted child, stepchild, eligible foster child, brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of these parties (e.g., grandchild, nephew, niece). Ancestors of any of these parties (e.g., uncles, aunts, cousins) and in-laws (e.g., son-in-law, brother-in-law) are not included. b. Once established by marriage, the relationship survives divorce. 23. The abode test. a. A qualifying child must live with the taxpayer for more than half of the year. Temporary absences are disregarded. 24. Age test. a. A qualifying child must be under age 19 or under age 24 in the case of a student. b. The age test does not apply to a child who is disabled during any part of the year. c. An individual cannot be older than the taxpayer claiming him or her as a qualifying child. 25. Joint return test. A married person cannot be claimed as a dependent if he or she files a joint return with his or her spouse - see item 30. below. 26. Citizenship or residency tests are applicable – see item 30. below. Qualifying Relative 3-8 2014 Individual Edition/Instructor’s Guide with Lecture Notes 27. A qualifying relative must meet a relationship test or member of the household test. a. Children, siblings, and their descendants qualify. b. Ascendants of the taxpayer (e.g., parents, grandparents), collateral relations (e.g., uncles, aunts), and in-laws are also included. c. The relationship test also includes unrelated parties who live with the taxpayer (i.e., are members of the same household) 28. Qualifying relative must meet the gross income test. a. A dependent’s gross income must be less than the exemption amount. Gross income is determined by the income that is taxable. 29. Qualifying relative must meet the support tests. a. Over one-half of the support of the qualifying relative must be furnished by the taxpayer. A scholarship is not included in support if a child is involved. b. A worksheet for determining support is contained in Table 3–1 located at the end of the Lecture Notes for this chapter (e.g., food, shelter, clothing, medical and dental care, and education). c. An exception to the more-than-50% test (as applied to a single taxpayer) involves the multiple support agreement. (1) Persons eligible must collectivelymeet the more-than-50% test. (2) To be eligible, persons must meet the relationship and more-than-10% tests. (3) Form 2120 (Multiple Support Declaration) must be used. (4) The multiple support agreement is particularly useful for adult children who are sharing in the support of parent(s). ETHICS & EQUITY Discovering Lost Dependency Exemptions (page 3-17). By completing multiple support agreements, Jesse’s children can file amended returns to claim him as a dependent. The dependency exemption can be rotated among the children and need not be claimed by the same child. The year of Jesse’s death (i.e., 2012) can be included, as a dependent need not be alive for the whole year. However, the usual three-year statute of limitations will preclude any claims for the earlier years of the six-year period. CHAPTER 3 Tax Determination, Exemptions, Property Transactions 3-9 d. An exception to the support test applies as to children of divorced or separated parents. The custodial parent is entitled to the exemption(s) unless he or she issues a waiver on Form 8332 (Release of Claim to Exemption of Child of Divorced or Separated Parents). [The noncustodial parent must attach the Form 8332 with his or her return.] 30. Joint return test and citizenship / residency test. a. A married person cannot be claimed as a dependent if he or she files a joint return with his or her spouse. b. A joint return is permissible if the filing was to recover withholdings, no tax liabilitywould be due on separate returns, and neither spouse is required to file. c. The dependent must be either a citizen or resident of the U.S. d. An exception is made for residents of Canada and Mexico. e. An exception is made for certain adopted children. PHASEOUT OF EXEMPTIONS 31. The phaseout is intended to reduce the benefits of personal and dependency exemptions to high bracket taxpayers. a. Since the phaseout affected higher bracket taxpayers, it is a type of stealth tax. b. There was no phaseout for 2010, but under a sunset provision, it was to be reinstated in 2011. c. TRA of 2010, however, postponed the reinstatement until January 1, 2013. ETHICS & EQUITY Whose Qualifying Child Is He? (Page 3-21) Under current law, Henry meets the definition of a qualifying child as to both his parents and his sister. If the tie-breaker rules are applied, the Rands (i.e., parents) would predominate over Belinda (i.e., sister). However, there is no need to apply the tie-breaker rules as no conflict exists. By their inaction, the parents have waived their prior right to claimHenry. Consequently, Belinda’s claim of Henry is entirely proper. . TAX DETERMINATION – FILING CONSIDERATIONS 3-10 2014 Individual Edition/Instructor’s Guide with Lecture Notes 32. Filing Requirements. The gross income level at which a taxpayer is required to file a return is generally equal to the sum of the taxpayer’s exemption amount plus the applicable standard deduction (see Table 3.4 in the text). a. Exceptions to general rule: The general rule described above does not apply to a taxpayer claimed as a dependent, a married individual filing separately, or a self- employed taxpayer. (1) In 2013, a taxpayer claimed as a dependent must file: • if he has earned income only and the gross income exceeds his total standard deduction; • if he has unearned income only and gross income of more than $1,000 plus any additional standard deduction allowed; or • if he has both earned and unearned income and gross income is more than the larger of earned income + $350 (but limited to the applicable standard deduction) or $1,000 plus any additional standard deduction allowed. (2) A married individual filing separately must file a return if gross income is equal to or greater than the exemption amount ($3,900 in 2013). (3) A self-employed individual with $400 or more of net earnings from a business or profession must file a return, regardless of the amount of gross income. 33. Additional Standard Deduction and Filing Requirements. For taxpayers age 65 or over, the additional standard deduction may or may not be considered in determining filing level requirements. a. The additional standard deduction for age is considered in determining filing requirements. b. The additional standard deduction for blindness is not considered in determining filing level requirements (except for those who can be claimed as dependents). c. Additional standard deductions for a
More Less

Related notes for ACCTMIS 3400

Log In


Don't have an account?

Join OneClass

Access over 10 million pages of study
documents for 1.3 million courses.

Sign up

Join to view


By registering, I agree to the Terms and Privacy Policies
Already have an account?
Just a few more details

So we can recommend you notes for your school.

Reset Password

Please enter below the email address you registered with and we will send you a link to reset your password.

Add your courses

Get notes from the top students in your class.