Chapter 04 - Individual Tax Overview

Chapter 4
Individual Tax Overview

HOMEWORK SOLUTIONS

Discussion Questions

1. [LO 1] How are realized income, gross income, and taxable income similar, and how are
they different?
Realized income is more broadly defined than gross income which is more broadly
defined than taxable income.
Gross income includes all realized income that taxpayers are not allowed to exclude
from gross income or are not permitted to defer to a later year. Consequently, gross
income is the income that taxpayers actually report on their tax returns and pay taxes on.
In the tax formula, taxable income is gross income minus allowable deductions for and
from AGI. Taxable income is the base used to compute the tax due before applicable
credits. However, any income included in gross income can be considered “taxable”
income because gross income is income that is taxable and causes an increase in the
taxes that a taxpayer is required to pay (gross income increases taxable income).

6. [LO 1] Are all capital gains (gains on the sale or disposition of capital assets) taxed at the
same rate? Explain.
No. If a taxpayer holds a capital asset for a year or less the gain is taxed at ordinary tax
rates. If the taxpayer holds the asset for more than a year before selling, the gain is
generally taxed at a maximum 15% rate but could be taxed as high as 20% for high
income taxpayers. If the taxpayer sells more than one capital asset during the year and
recognizes both capital gains and capital losses, the gains and losses are netted together
before determining the applicable tax rate.

7. [LO 1] Are taxpayers allowed to deduct net capital losses (capital losses in excess of
capital gains)? Explain.
In general, a taxpayer is allowed to deduct, as a “for AGI deduction,” up to $3,000 of
net capital loss against ordinary income. If the net capital loss exceeds $3,000, the
taxpayer is allowed to carry the loss over indefinitely to deduct in subsequent years
(subject to the $3,000 annual deduction limitation). If however, a capital loss arises
from the sale of a personal use asset (such as a personal automobile or a personal
residence), the loss is not deductible.

11. [LO 1]. Why are some deductions called “above-the-line” deductions and others are
called “below-the-line” deductions? What is the “line”?
The line is adjusted gross income (AGI). AGI is considered the line because of the
significance it plays in the amount of deductions allowed from AGI. “For AGI”
deductions are called above-the-line deductions because they are deducted in
determining AGI. “From AGI” deductions are called below-the-line deductions because

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they are deducted after AGI has been determined. They are deducted from AGI to arrive
at taxable income. Below-the-line deductions may be subject to limitations based on the
taxpayer’s AGI.

16. [LO 2] Emily and Tony are recently married college students. Can Emily qualify as her
parents’ dependent? Explain.
Depending on the circumstances, Emily may qualify as a dependent of her parents. A
taxpayer who files a joint return with his or her spouse may not qualify as a dependent of
another, unless there is no tax liability on the couple's joint return and there would not
have been any tax liability on either spouse’s tax return if they had filed separately. As
long as Emily and Tony meet these criteria, then Emily will qualify as a dependent of her
parents assuming she also meets tests to be her parents’ qualifying child or qualifying
relative.

Problems
26. [LO 1] Jeremy earned $100,000 in salary and $6,000 in interest income during the year.
Jeremy has two qualifying dependent children who live with him. He qualifies to file as head
of household and has $17,000 in itemized deductions. Neither of his dependents qualifies for
the child tax credit.

a. Use the 2013 tax rate schedules to determine Jeremy’s taxes due.

Jeremy will owe $13,827.50 calculated as follows:

Description Amount Computation

(1) Gross income 106,000 $100,000 salary + $6,000
interest income
(2) For AGI deductions 0
(3) Adjusted gross income $106,000 (1) – (2)
(4) Standard deduction 8,950 Head of household
(5) Itemized deductions 17,000
(6) Greater of standard deductions or 17,000 (5) > (4)
itemized deductions
(7) Personal and dependency 11,700 3,900 × 3 (personal
exemptions exemption and two
dependency exemptions)
(8) Taxable income $77,300 (3) - (6)- (7)

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Income tax liability $13,827.50 (77,300 – 48,600) × 25%

+ $6,652.50 (see tax rate
schedule for head of
household)

b. Assume that in addition to the original facts, Jeremy has a long-term capital gain of
$4,000. What is Jeremy’s tax liability including the tax on the capital gain (use the tax rate
schedules rather than the tax tables)?

Jeremy will owe $14,427.50 calculated as follows:

Description Amount Computation

(1) Gross income 110,000 $100,000 salary + $6,000 interest
income + 4,000 long-term capital
gains
(2) For AGI deductions 0
(3) Adjusted gross income $110,000 (1) – (2)
(4) Standard deduction 8,950 Head of household
(5) Itemized deductions 17,000
(6) Greater of standard 17,000 (5) > (4)
deductions or itemized
deductions
(7) Personal and dependency 11,700 3,900 × 3 (personal exemption and
exemptions two dependency exemptions)
(8) Taxable income $81,300 (3) – (6) – (7)
Income tax liability $14,427.5 ($77,300 – 48,600) × 25% + 6,652.5
+ 4,000 × 15% (See tax rate
schedule for head of household.
Also note that the qualified dividend
is taxed at a maximum rate of 15%.)

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c. Assume the original facts except that Jeremy had only $7,000 in itemized deductions.
What is Jeremy’s total income tax liability (use the tax rate schedules rather than the tax
tables)?

Jeremy will owe $15,840, calculated as follows:

Description Amount Computation

(1) Gross income 106,000 $100,000 salary + $6,000
interest income
(2) For AGI deductions 0
(3) Adjusted gross income $106,000 (1) – (2)
(4) Standard deduction 8,950 Head of household
(5) Itemized deductions 7,000
(6) Greater of standard deductions or 8,950 (4) > (5)
itemized deductions
(7) Personal and dependency 11,700 3,900 × 3 (personal
exemptions exemption and two
dependency exemptions)
(8) Taxable income $85,350 (3) – (6) – (7)
Income tax liability $15,840 (85,350– 48,600) × 25% +
6,652.5 (see tax rate
schedule for head of
household)

30. [LO 1] {Planning} Matteo,who is single and has no dependents, was planning on
spending the weekend repairing his car. On Friday, Matteo’s employer called and
offered him $500 in overtime pay if he would agree to work over the weekend. Matteo
could get his car repaired over the weekend at Autofix for $400. If Matteo works over
the weekend, he will have to pay the $400 to have his car repaired, but he will earn $500.
Assume Matteo pays tax at a flat 15 percent rate?

a. Strictly considering tax factors, should Matteo work or repair his car if the $400
he must pay to have his car fixed is not deductible?

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If Matteo works, he will receive $500, but he will have to pay $75 in taxes ($500 x 15%),
netting him $425. He then must pay $400 for his car to be repaired which means he will
save $25 ($425 – 400) by working. If he doesn’t work, he won’t have any income, he
won’t pay any taxes, and he won’t have to pay to have his car repaired. Overall, he
would be $25 better off by working.
Note that taxes may not be the only concern here. Matteo would also need to factor in
how much he enjoys repairing his car and how much he enjoys working. He could also
consider whether he will do a better job repairing his car or whether Autofix could do a
better job

b. Strictly considering tax factors, should Matteo work or repair his car if the $400
he must pay to have his car fixed is deductible for AGI?
If Matteo works, he will receive $500, and he will be allowed to deduct the $400 repair
expense, leaving him with taxable income of $100 ($500 – 400) on which he will pay $15
in taxes. So, if he works, he will receive $500, pay $400 to have his car fixed, and pay
$15 in taxes, leaving him with $85. If he doesn’t work, he won’t have any income, he
won’t pay any taxes, and he won’t be out of pocket because he will do his own repair
work (assuming the repair only requires labor). So, he’s $85 better off by working and
having his car repaired by Autofix.
Note that taxes may not be the only concern here. Matteo would also need to factor in
how much he enjoys repairing his car and how much he enjoys working. He could also
consider whether he will do a better job repairing his car or whether Autofix could do a
better job.

32. [LO 2] Aishwarya’s husband passed away in 2012. She needs to determine whether
Jasmine, her 17-year old step-daughter who is single, qualifies as her dependent in 2013.
Jasmine is a resident but not a citizen of the United States. She lived in Aishwarya’s
home from June 15 through December 31, 2013. Aishwarya provided more than half of
Jasmine’s support for the 2013.

a.Is Aishwarya allowed to claim a dependency exemption for Jasmine for 2013?
Yes, Aishwarya may claim a dependency exemption for Jasmine in 2013. Jasmine meets the
citizenship/residency test because she is a resident of the United States, and she meets the
requirements to be considered Aishwarya’s qualifying child as follows:

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Test Jasmine
Relationship Yes, stepdaughter qualifies
Age Jasmine is under 19 at the end of the year
Residence Jasmine had the same principal residence as Aishwarya for more
than half the year
Support Jasmine does not provide more than half her own support.

b. Would Aishwarya be allowed to claim a dependency exemption for Jasmine for 2013 if
Aishwarya provided more than half of Jasmine’s support in 2013, Jasmine lived in
Aishwarya’s home from July 15 through December 31 of 2013, and Jasmine reported gross
income of $5,000 in 2013?

No. Jasmine would fail the qualifying child test because she did not have the same principal
residence as Aishwarya for more than half the year. Jasmine would fail the qualifying relative
test because her gross income exceeds the $3,900 personal exemption amount for 2013.

c. Would Aishwarya be allowed to claim a dependency exemption for Jasmine for 2013 if
Aishwarya provided more than half of Jasmine’s support in 2013, Jasmine lived in
Aishwarya’s home from July 15 through December 31 of 2013, and Jasmine reported gross
income of $2,500 in 2013?

Yes, Jasmine would qualify as Aishwarya’s qualifying relative as follows:

Test Jasmine
Relationship Yes, stepdaughter qualifies
Support Aishwarya provided more than half of Jasmine’s support
Gross income Jasmine’s gross income does not exceed the dependency
exemption amount.

33. [LO 2] The Samsons are trying to determine whether they can claim their 22-year-old
adopted son, Jason, as a dependent. Jason is currently a full-time student at an out-of-
state university. Jason lived in his parents’ home for three months of the year, and he
was away at school for the rest of the year. He received $9,500 in scholarships this year
for his outstanding academic performance and earned $4,800of income working a part-
time job during the year. The Samsons paid a total of $5,000to support Jason while he
was away at college. Jason used the scholarship, the earnings from the part-time job, and
the money from the Samsons as his only sources of support.

a. Can the Samsons claim Jason as their dependent?

Yes, the Samsons may claim Jason as their dependent. He is their qualifying child. See the
following analysis.

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Test Jason
Relationship Yes, adopted son qualifies
Age Yes, under age 24 and a full-time student (and younger than
parents).
Residence Yes, temporary absences away at school count as time in the
parents’ home.
Support Yes. The Samsons provided $5,000 of support for Jason. Jason
provided $4,800 of his own support (Jason did not provide more
than half his own support). Jason also received $9,500 of
scholarship money, but this does not count as support provided
for himself because he is an actual child of the Samsons.

b. Assume the original facts except that Jason’s grandparents, not the Samsons, provided
him with the $5,000 worth of support. Can the Samsons (Jason’s parents) claim Jason as
their dependent? Why or why not?

Yes, the Samsons may claim Jason as their dependent. Jason is their qualifying child. See the
following analysis.

Test Jason
Relationship Yes, Jason is their (adopted) son.
Age Yes, under age 24 and a full-time student (and younger than his
parents).
Residence Yes, temporary absences away at school count as time in the
parents’ home.
Support Yes, even though Jason’s parents did not provide any of his
support, Jason did not provide more than half of his own support
because his grandparents provided $5,000 of support for Jason.
Jason provided $4,800 of his own support. Jason also received
$9,500 of scholarship money, but this does not count as support
provided for himself because he is an actual child of the Samsons,
who are claiming him as a dependent.

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c. Assume the original facts except substitute Jason’s grandparents for his parents.
Determine whether Jason’s grandparents can claim Jason as a dependent.

No, the grandparents may not claim Jason as a dependent. He is neither a qualifying child nor
a qualifying relative.
Test Jason
Relationship Yes, Jason is the descendant of the taxpayers’ child (one of
Jason’s parents is the child of the taxpayer’s grandparents)
Age Yes, under age 24 and a full-time student (and younger than his
grandparents).
Residence Yes, temporary absences away at school count as time in the
grandparents’ home since that is his permanent residence.
Support No, Jason’s grandparents provided $5,000 of support. Jason
provided $4,800 of his own support through his part time job. He
also provided $9,500 of his own support through a scholarship.
In this case, because the taxpayers are not Jason’s parents, the
$9,500 scholarship counts as support provided by Jason. So, he
provides more than half his own support, and he does not meet
the support test to qualify as a qualifying child of his
grandparents. Because the grandparents did not provide more
than half of Jason’s support, Jason would not qualify as a
qualifying relative either.

d. Assume the original facts except that Jason earned $5,500 while working part-time and
used this amount for his support. Can the Samsons claim Jason as their dependent? Why
or why not?

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No, the Samsons may not claim Jason as their dependent. He is neither their qualifying child
nor their qualifying relative. See the following analysis.
Test Jason
Relationship Yes, adopted son qualifies
Age Yes, under age 24 and a full-time student (and younger than his
parents).
Residence Yes, temporary absences away at school count as time in the
parents’ home.
Support No,the Samsons provided $5,000 of support for Jason. Jason
provided $5,500 of his own support. Jason also received $9,500
of scholarship money, but this does not count as support provided
for himself because he is an actual child of the
Samsons.Nevertheless, because Jason provided more than half of
his own support, he is neither a qualifying child nor a qualifying
relative to his parents. Jason could also not be a qualifying
relative because his income of $5,500 was greater than the
personal exemption amount.

37. [LO 2, 3] Dean Kastner is 78 years old and lives by himself in an apartment in Chicago.
Dean’s gross income for the year is $2,500. Dean’s support is provided as follows:
Himself (5%), his daughters Camille (25%) and Rachel (30%), his son Zander (5%), his
friend Frankie (15%), and his niece Sharon (20%).

a. Absent a multiple support agreement, of the parties mentioned in the problem, who
may claim a dependency exemption for Dean as a qualifying relative?

Because they do not provide over half of Dean’s support individually, neither Camille,
Rachel, Zander, Frankie, nor Sharon is eligible to claim Dean as a dependent qualifying
relative. In addition, Frankie fails the relationship test because he is unrelated to Dean,
and he did not live with Dean for the entire year (he did not live with him at all during the
year).

b. Under a multiple support agreement, who is eligible to claim a dependency

exemption for Dean as a qualifying relative? Explain.

Camille, Rachel, and Sharon are eligible because of the following:

1. No one taxpayer paid over half the support for Dean.
2. Together, Camille, Rachel, Sharon, and Zander provided more than half of Dean’s
support (80%) and Camille, Rachel, Sharon, and Zander would have each been able to
claim a dependency exemption for Dean except for the fact that each did not meet the
support test (Frankie fails the relationship test for qualifying relative)
3. Camille, Rachel, and Sharon each provided over 10% of Dean’s support.

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4. Camille, Rachel, and Sharon can claim the exemption, but the two parties who do not
claim it must provide a signed statement to the person claiming the exemption stating
that she will not claim an exemption for Dean. The person claiming the exemption
would attach a Form 2120 to her return indicating the names, addresses, and social
security numbers of the two who did not claim Dean as a dependent.

c. Assume that Camille is allowed to claim Dean as a dependent under a multiple

support agreement. Camille is single and Dean is her only dependent. What is
Camille’s filing status?

Camille must file as a single taxpayer. Because she claims Dean as a dependent under a
multiple support agreement, Dean is not a qualifying person for purposes of determining
head of household status for Camille.

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