TAX FORMULA AND TAX DETERMINATION;
AN OVERVIEW OF PROPERTY TRANSACTIONS
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
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
Accident insurance proceeds
Child support payments
Life insurance paid on death of insured
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.
Compensation for services
Gains from illegal activities
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
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
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.,
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
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
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
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
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.
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.
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
20. A qualifying child must satisfysix tests:
• 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
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%
(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-
(1) In 2013, a taxpayer claimed as a dependent must file:
• if he has earned income only and the gross income exceeds his total
• 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
(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
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
a. The additional standard deduction for age is considered in determining filing
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