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THE INDIVIDUAL INCOME TAX FORMULA LO1 Each year, individuals file tax returns to report their taxable income, the tax base for the individual income tax, to the Internal Revenue Service. Exhibit 4-1 presents a simplified formula for calculating taxable income.

EXHIBIT 4-1 Individual Tax Formula Beginning with gross income, this formula is imbedded in the first two pages of the individual income tax Form 1040, the form individuals generally use to report their taxable income. Exhibit 4 -2 presents the first two pages from the form (throughout the text we use 2011 tax forms because 2012 forms were unavailable when the book went to press). The last line on page 1 of Form 1040 is adjusted gross income (AGI), an important reference point in the income tax formula.

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EXHIBIT 4-2 Form 1040, pages 1 and 2 Page 04-3 Let's look at the components of the individual tax formula and provide a brief description of each of the key elements. Gross Income The U.S. tax laws are based on the all-inclusive income concept. Under this concept, gross income generally includes all realized income from whatever source derived.1 Realized income is generated in a transaction with a second party in which there is a measurable change in property rights between parties (appreciation in a stock investment would not represent realized income unless the taxpayer sold the stock). Certain tax provisions allow taxpayers to permanently exclude specific types of realized income from gross income (the income items are never taxable) and other provisions allow taxpayers to defer including certain types of realized income items in gross income until a subsequent year (the income item is included in gross income in a later year). Realized income items that taxpayers permanently exclude from taxation are referred to as exclusions. Realized income items that taxpayers include in gross income in a subsequent year are called deferrals. Exhibit 4-3 provides a partial listing of common income items included in gross income and indicates where in the text we provide more detail on each income item. Exhibit 4-4 provides a partial listing of common exclusions and deferrals and indicates where in the text we discuss each in more detail.

EXHIBIT 4-3 Partial Listing of Common Income Items

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EXHIBIT 4-4 Partial Listing of Common Exclusions and Deferrals Page 04-5 Character of Income While gross income increases taxable income dollar for dollar, it is important to note that not all types of income are treated equally. In fact, the type of income (commonly referred to as the character of income) determines the rate at which the income will be taxed. The different types or characters of income are as follows: Tax-exempt: This is income realized during the year that is excluded from gross income and is never taxed (income qualifies as an exclusion). Tax deferred: This is income realized during the year that is not included in gross income until a later year(s) (the current year tax rate is zero). That is, the income is not taxed in the current year but will be taxed in a subsequent year or years when certain events take place (the income qualifies as a deferral). Ordinary: This is income included in gross income (or loss subtracted in determining gross income) in the current year and taxed at the ordinary rates provided in the tax rate schedules. Qualified dividend: Shareholders receiving dividends from corporations include the dividend income in gross income. If the dividend meets the qualified dividend requirements, it is taxed at a maximum rate of 15 percent (0 percent if it would have been taxed at a 15 percent or lower rate if it were ordinary income). If the dividend does not meet these requirements, it is taxed as ordinary income. Because qualified dividends are subject to a lower rate than ordinary income (a preferential tax rate), qualified dividends can be referred to as preferentially taxed income. A qualified dividend generally includes dividends distributed by a U.S. corporation if the shareholder meets certain holding requirements for the stock. 2 These requirements are discussed in more detail in Chapter 11. Page 04-6 Capital: These are gains or losses on the disposition or sale of capital assets. In general, capital assets are all assets other than 1. Accounts receivable from the sale of goods or services. 2. Inventory and other assets held for sale in the ordinary course of business. 3. Assets used in a trade or business, including supplies.3 Thus, personal use assets such as a personal automobile or personal residence and assets held for investment such as stocks and bonds are capital assets. Gain on the sale of a capital

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asset is generally included in gross income. If the gain is a long-term capital gain (the taxpayer owned the capital asset for more than a year before selling it), it is taxed at a maximum 15 percent tax rate (0 percent if the gain would have been taxed at a 15 percent or lower rate if it were ordinary income). If the gain is a short-term capital gain (the taxpayer holds the asset for a year or less before selling it), the gain is taxed at ordinary income rates. Loss on the sale of a capital asset (no matter how long the taxpayer held it before selling) is a for AGI deduction in the year of sale. However, the deduction for a capital loss in a particular year is limited to $3,000 (losses in excess of the limit are carried forward indefinitely). If the taxpayer sells a personal use asset (like a personal automobile or personal residence) at a loss, the loss is not deductible. When a taxpayer sells more than one capital asset during the year, the gains and losses are netted together. A net loss is subject to the $3,000 annual for AGI deduction limit. A net gain may be taxed at the maximum rate of 15 percent or at the ordinary rates depending on the outcome of the netting process. We discuss the netting process in detail in Chapter 11.4 Example 4-1 Rodney earned a salary of $64,000, and Anita earned a salary of $46,000 working part-time. The Halls also received $600 of interest income from investments in corporate bonds and $300 of interest income from investments in municipal bonds. This was their only income during the year. What is the Halls' gross income? Answer: $110,600, computed as follows: Description Amount Explanation (1) Rodney's salary $ 64,000 (2) Anita's salary 46,000 (3) Interest from corporate bonds 600 Gross income $110,600*(1) + (2) + (3). *The $300 of interest income is excluded from gross income. What is the character of the salary, the interest income from the corporate bonds, and the interest income from the investments in municipal bonds? Answer: The salary and interest income from corporate bonds are ordinary income. The interest income from the municipal bonds is tax-exempt income. Page 04-7 What if: Suppose this year the Halls sold stock at a $4,000 gain. They purchased the stock three years ago. What would be the character of the gain? At what rate would the gain be taxed? Answer: Long-term capital gain because stock is a capital asset and the Halls owned the stock for more than a year before selling. The gain would be taxed at a maximum rate of 15 percent. What if: Suppose this year the Halls sold stock at a $4,000 loss. They purchased the stock three years ago. What would be the character of the loss? How much of the loss may the Halls deduct in the current year? Answer: Long-term capital loss because the stock is a capital asset and the Halls owned the stock for more than a year before selling. The Halls can deduct $3,000 of the loss as a for AGI deduction. The remaining $1,000 loss is carried over to next year.

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What if: Suppose this year the Halls sold a personal automobile at a $4,000 loss. They purchased the automobile three years ago. What is the character of the loss? How much of the loss may the Halls deduct in the current year? Answer: Long-term capital loss because the automobile is a capital asset and the Halls owned the auto for more than a year before selling. However, the Halls are not allowed to deduct any of the $4,000 loss this year or any year because the automobile is a personal use asset. Deductions Deductions reduce a taxpayer's taxable income. However, they are not necessarily easy to come by because, in contrast to the all-inclusive treatment of income, taxpayers are not allowed to deduct anything unless a specific tax provision allows them to do so. Thus, deductions are a matter of legislative grace. The tax laws provide for two distinct types of deductions in the individual tax formula: for adjusted gross income (AGI) deductions and from AGI deductions. As indicated in the individual tax formula, gross income minus for AGI deductions equals AGI and AGI minus from AGI deductions equals taxable income. When it enacts new legislation that grants deductions, Congress typically identifies whether the deductions are for or from AGI. The distinction between the deduction types is particularly important because AGI is an important reference point that is often used in other tax-related calculations. Specifically, limits on certain from AGI deductions depend on AGI (certain from AGI deductions are reduced as a taxpayer's AGI increases). Because for AGI deductions decrease AGI, they increase the deductibility of from AGI deductions subject to AGI limitations. THE KEY FACTS For and From AGI Deductions For AGI deductions Deduct in determining AGI. Above the line deduction. Generally more valuable than from AGI deductions. From AGI deductions Deducted from AGI to determine taxable income. Below the line deduction. Generally less valuable than for AGI deductions. For AGI Deductions For AGI Dedctions For AGI deductions tend to be deductions associated with business activities and certain investing activities. Because for AGI deductions are subtracted in determining AGI (deducted on page 1 of Form 1040), they are referred to as deductions above the line. The line in this case is AGI, which is the last line on page 1 of Form 1040 (see Exhibit 4-2). Exhibit 4-5 provides a partial listing of common for AGI deductions and indicates where in the text we discuss them.

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EXHIBIT 4-5 Partial Listing of Common for AGI Deductions Page 04-8 Example 4-2 The Halls paid $5,000 of deductible moving expenses (for AGI) when the family relocated due to an employment transfer for Rodney. What is the Halls' adjusted gross income? Answer: $105,600, computed as follows: Description Amount Explanation (1) Gross income $110,600 Example 4-1. (2) Moving expenses (5,000)For AGI deduction (see Exhibit 4-5). Adjusted gross income$105,600 (1) + (2). From AGI Deductions In contrast to for AGI deductions, from AGI deductions tend to be personal in nature. From AGI deductions are commonly referred to as deductions below the line because they are deducted after AGI has been determined (deducted on page 2 of Form 1040). From AGI deductions include itemized deductions, the standard deduction, and exemptions. In a given year, individuals have the choice of deducting either their itemized deductions or deducting a fixed amount called the standard deduction. They generally deduct the higher of the two. Exhibit 4-6 identifies the primary categories of itemized deductions.

Note: Itemized deductions are discussed in more detail in Chapter 6. EXHIBIT 4-6 Primary Categories of Itemized Deductions The amount of the standard deduction varies by taxpayer filing status (we discuss filing status in more detail later in the chapter); the government indexes this deduction for inflation. Exhibit 4-7 presents the basic standard deduction amounts by filing status for 2011 and 2012. Special rules

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may alter the allowable standard deduction for certain taxpayers. We discuss these departures from the basic standard deduction amounts in Chapter 6.

*Married taxpayers 65 years of age or over and/or blind are entitled to an additional standard deduction of $1,150 ($1,150 for age and another $1,150 for blindness); single and head of household taxpayers 65 years of age or over and/or blind are entitled to an additional standard deduction of $1,450 (one for age and another for blindness). (See Chapter 6 for more detail.) For individuals claimed as a dependent on another tax return, the 2012 standard deduction is the greater of (1) $950 or (2) $300 plus earned income not to exceed the standard deduction amount for those who are not dependents (see Chapter 7 for more detail). EXHIBIT 4-7 Standard Deduction Amounts by Filing Status* Page 04-9 The final from AGI deduction is the deduction for exemptions. An exemption is a flat deduction allowed for the taxpayer, the taxpayer's spouse, and each person who qualifies as a dependent of the taxpayer. The exemptions for the taxpayer(s) filing the tax return are called personal exemptions, while the others are referred to as dependency exemptions. In 2012, the amount of the exemption deduction is $3,800 for both exemption types. We discuss the dependency qualification requirements later in this chapter. Example 4-3 Tara's parents, Rodney and Anita, annually file a joint tax return. Tara determined that her parents paid a total of $14,000 for expenditures that qualify as itemized deductions. Assuming Tara and her younger brother Braxton qualify as Rodney and Anita's dependents, what is the total amount of from AGI deductions Rodney and Anita are allowed to deduct on their tax return? Answer: $29,200, computed as follows: Description (1) Standard deduction (2) Itemized deductions (3) Greater of (1) or (2) (4) Personal and dependency exemptiona Total deductions from AGI Amount Explanation $11,900Married filing joint filing status (see Exhibit 4-7). 14,000 14,000Itemized deductions exceed the standard deduction. 15,200($3,800 4) One each for Rodney, exemptions Anita, Tara, and Braxton. $29,200(3) + (4). (Also referred to as deductions below the line.)

What if: What would be the amount of the Halls' from AGI deductions if, instead of the original facts, Rodney and Anita had paid a total of $8,000 in expenditures that qualified as itemized deductions, such as interest expense and gifts to charity? Answer: $27,100, computed as follows:

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Description Amount Explanation (1) Standard deduction $11,900Married filing joint filing status (see Exhibit 4-7). (2) Itemized deductions 8,000 (3) Greater of (1) or (2) 11,900The standard deduction exceeds itemized deductions. (4) Personal and dependency 15,200($3,800 4) One personal exemption each for exemptions exemption Rodney, Anita, Tara, and Braxton. Total deductions from $27,100(3) + (4). AGI Income Tax Calculation After determining taxable income, taxpayers can generally calculate their regular income tax liability using either a tax table or a tax rate schedule, depending on their filing status and income level (see inside back cover for the regular tax rate schedule and see the appendix at the end of the chapter for an excerpt from a tax table). Taxpayers with taxable income under $100,000 generally must use the tax tables.5 However, as we discussed above, certain types of income that are included in taxable income are taxed at rates different from the rates embedded in the tables or published in the tax rate schedules. Page 04-10 Example 4-4 With Tara's help, the Halls determined their taxable income to be $76,400 as follows: Description Amount Explanation (1) Adjusted gross income$105,600Example 4-2. (2) From AGI deductions (29,200) Example 4-3. Taxable income $ 76,400 (1) + (2). They have also determined that all of their income is ordinary income. What is their tax liability (use the tax rate schedule rather than the tax tables to answer the question)? Answer: $11,160.See the married filing jointly tax rate schedule inside the back cover. [$9,735 + $1,425 {25% ($76,400 $70,700)}]. What if: Suppose the Halls reported $76,400 of taxable income in 2011; what would be their 2011 tax liability using the tax tables (see the appendix at the end of this chapter. Note that in the appendix we use a 2011 tax table because the 2012 tax table was unavailable at press time). Answer: $11,356. What if: Using the tax rate schedules, what would the Halls' tax liability be if their taxable income was $12,000 (all ordinary income)? Answer: $1,200 ($12,000 10%). What if: Assume that in addition to the $76,400 of ordinary income, the Halls also reported $5,000 of long-term capital gain subject to a 15 percent tax rate. How much tax would they pay on the additional $5,000 gain? Answer: $750 ($5,000 15%). Long-term capital gains (gains on the sale of a capital asset owned for more than a year) are generally taxed at a 15 percent rate. Note that the Halls' taxable income is $81,400. $76,400 of the income is taxed at ordinary rates and $5,000 is taxed at the preferential 15 percent rate.

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Other Taxes In addition to the individual income tax, individuals may also be required to pay other taxes such as the alternative minimum tax (AMT) or self-employment taxes. These taxes are imposed on tax bases other than the individual's regular taxable income. We discuss both taxes in more detail in Chapter 7. Tax Credits Individual taxpayers may reduce their tax liabilities by tax credits to determine their total taxes payable. Like deductions, tax credits are specifically granted by Congress and are narrowly defined. Unlike deductions, which reduce taxable income, tax credits directly reduce taxes payable. Thus, a $1 deduction reduces taxes payable by $1 times the marginal tax rate while a $1 credit reduces taxes payable by $1. Common credits include the child tax credit ($1,000 per child that qualifies for the credit), the child and dependent care credit, the earned income credit, the American opportunity credit, and the lifetime learning credit. We discuss credits in more detail in Chapter 7. Tax Prepayments After calculating the total tax and subtracting their available credits, taxpayers determine their taxes due (or tax refund) by subtracting tax prepayments from the total tax remaining after credits. Tax prepayments include (1) withholdings, or income taxes withheld from the taxpayer's salary or wages by her employer; (2) estimated tax payments the taxpayer makes for the year (paid directly to the IRS), and (3) taxes the taxpayer overpaid on the prior year tax return that the taxpayer elects to apply as an estimated payment for the next tax year instead of receiving the overpayment as a refund. Page 04-11 If tax prepayments exceed the total tax after subtracting credits, the taxpayer receives a tax refund for the difference. If tax prepayments are less than the total tax after credits, the taxpayer owes additional tax and potentially a penalty for the underpayment. Example 4-5 Based on their calculation in Example 4-4, Rodney and Anita Hall's tax liability is $11,160. The Halls had $10,110 of federal income taxes withheld by their employers from their paychecks and are able to claim a $1,000 child tax credit for their 12-year-old son Braxton (Tara is too old to qualify). What is the Halls' tax due or tax refund? Answer: $50 taxes due, computed as follows: Description Amount Explanation (1) Tax liability $ 11,160Example 4-4. (2) Tax credits (1,000)$1,000 child tax credit for 12-year old son Braxton. (3) Tax prepayments(10,110) Tax due $ 50(1) + (2) + (3). Although not explicitly stated in the individual tax formula, a taxpayer's filing status affects many parts of the tax formula, including the standard deduction amount and the applicable income tax rate schedule among others. Below, we describe the rules for determining a taxpayer's filing status. However, because a taxpayer's filing status may depend on whether the taxpayer has

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dependents for tax purposes, we discuss how to determine who qualifies as a taxpayer's dependent before we address filing status.
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61(a). Dividends from qualified foreign corporations may also qualify [see 1(h)(11)(B)]. See 1221(a) for the definition of a capital asset.

As we discover in Chapter 11, certain capital gains may be taxed at a maximum rate of 28 percent or 25 percent. For administrative convenience and to prevent low- and middle-income taxpayers from making mathematical errors using a rate schedule, the IRS provides tax tables that present the gross tax for various amounts of taxable income. For simplicity, we use the tax rate schedule to determine tax liabilities in the examples presented in this text.
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