Chapter 11

Income Taxation
of
Individuals

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 Individual Income Tax Model

Gross income
Less: Deductions for adjusted gross income
Equals: Adjusted Gross Income (AGI)
Less: Itemized or standard deduction
Less: Personal & dependency exemptions
Equals: Taxable income

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 Tax Model (continued)

Taxable income
Times: Tax rate
Equals: Gross income tax liability
Less: Tax credits
Plus: Additions to tax
Less: Tax prepayments
Equals: Net tax due or tax refund

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 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

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 Deductions For AGI

Deductions discussed in this chapter

Educator expenses
Student loan interest expense
Tuition and fees deduction
Penalty on early withdrawals of savings
Health savings accounts
National guard & military reserve travel

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 Educator Expenses

Kindergarten through 12th grade teachers may

deduct up to $250 of unreimbursed expenses
for books, supplies, computer equipment,
software, and other supplemental materials
used in the classroom
Expired at end of 2003 but expected to be
extended retroactively by Congress

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 Student Loan Interest

Deduction allowed for interest paid on qualified

student loans incurred and used for tuition,
fees, room, board, books, and supplies
Deduction limit is $2,500
Limit is phased out for modified AGI of $50,000
- $65,000 ($100,000 - $130,000 for married
persons filing jointly)
Individuals claimed as dependents cannot take
deduction on their own tax return
Expenses paid by tax-exempt scholarships or
subject to education credits must be excluded
from loan amounts and related interest
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 Tuition & Fees Deduction

$4,000 deduction for 2004-2005 for tuition & fees

for taxpayer, spouse, and dependents
Income limits apply ($65,000 if single and $130,000 if
married filing jointly)
Deduction is reduced to $2,000 for singles with
income $65,000 - $80,000 ($130,000 - $160,000
for joint filers)
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)
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 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

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 Health Savings Accounts

Taxpayers covered by high-deductible

medical insurance policies only may deduct
amounts set aside in an MSA or HSA
Contributions and earnings on MSAs and
HSAs are not taxed when withdrawn to pay
medical expenses
For MSAs, qualified policies are those with
deductibles of $1,700 - $2,600 for individuals
($3,450 - $5,150 for families) in 2004
Contributions to MSAs are limited to 65% of policy
deductible for individuals (75% for families)

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 Health Savings Accounts

HSAs are similar to MSAs but with different

limits
In 2004, individuals with deductibles of at least
$1,000 ($2,000 for families) can qualify for a
deduction equal to lesser of $2,250 ($4,500 for
families) or the annual policy deductible
Distributions not spent on qualifying
expenses are included in income and subject
to a 10% penalty for HSAs and 15% penalty
for MSAs
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 Special Travel Deduction

For nonreimbursed travel expenses to

attend National Guard or military reserve
meetings more than 100 miles from home
Maximum deduction is general
government per diem rate for the area
Excess expenses can be deducted as
miscellaneous itemized deductions
(subject to 2% of AGI floor)

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 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

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 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

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 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

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 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
year
Single

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 Head of Household

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

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 Head of Household

Qualifying relatives include brothers, sisters,

parents, grandparents, nieces and nephews
by blood, aunts and uncles (defined as
brother or sister of father or mother)
Cousins and more distant relatives are not
included in the definition of qualifying relatives

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 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 who
provides more than half the cost of maintaining
the home in which a dependent child lives
A qualifying abandoned spouse uses head of
household tax rates and standard deduction

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 Exemptions

Each taxpayer (who is not a dependent) is

entitled to one personal exemption
Exemption deduction is $3,100 for 2004
Additional exemptions allowed for each
person who is considered a dependent
Anyone who is claimed as a dependent
cannot claim a personal exemption

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 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

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 Relative or
Member-of-Household Test
The dependent must be either be a
qualifying relative (including a child,
grandchild, brother, sister, parent,
grandparent, niece, nephew, aunt and uncle)
or
A member of the taxpayers household for
the entire taxable year

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 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 student
Nontaxable income used for support must
be included in support determination

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 Multiple Support Agreement

Multiple support agreements allow one

member of group of support providers to
claim the exemption when
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 and other
members providing 10% support agree to
exemption

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 Gross Income Test

The dependent's gross income from

taxable sources must be less than the
exemption amount ($3,100 for 2004)
The gross income test is waived for
Child of taxpayer who is under age 19 at
year end or
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

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 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 thresholds
$142,700 if single
$178,350 if head of household
$214,050 if married filing jointly
$107,025 if married filing separately

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 Exemption Phaseout

(1) (AGI threshold AGI)/$2,500 = Phaseout Factor

(always round up to next whole number)
(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

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 Standard Deductions

Standard Deductions
$9,700 married filing a joint return
$4,850 married filing separately
$7,100 head of household
$4,850 single individual
Add on standard deduction if taxpayer is elderly
(age 65 or older) or blind
$1,200 if single or head of household
$950 if married

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 Dependents Standard Deduction

Dependents standard deduction is limited to the

greater of:
(1) $800 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

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 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

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 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 health
insurance costs

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 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

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 Taxes

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 activity

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 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 use
Assessments on property that increase
property value

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 Interest Expense

Deductible interest includes

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
payments (except previously mentioned
student loan interest)

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 Investment Interest Expense

Investment interest includes interest on loans to

acquire or hold investment property and margin
account 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

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 Investment Interest Expense

Investment income includes 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 includes safe deposit box
rental fees, investment counsel fees, brokerage
account maintenance fees
Limited to the lesser of total investment
expenses or net miscellaneous itemized
deductions after reduction for 2% AGI floor
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 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 amount (combined limit for 2 homes)
is deductible
Acquisition debt includes mortgage to buy,
construct, or improve the residence

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 Qualified Residence Interest

Interest on up to $100,000 principal amount

of home equity loan is deductible
Loan proceeds can be used for any purpose
Points (loan origination fees) paid on initial
home mortgages are deductible
Points paid to refinance an exiting loan must
be amortized over life of loan

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 Charitable Contributions

Congress allows individuals, corporations,

estates and trusts to deduct contributions to
certain qualified organizations
Partnerships and S corporations pass the
contributions through to their partners and
shareholders who then claim the deductions
on their own income tax returns

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 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 agencies
Direct contributions to needy individuals are not
deductible

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 Charitable Contributions

No deduction allowed to the extent that valuable

goods or services are received in return for the
contribution
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 may be carried forward up
to 5 years

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 Charitable Contributions

No deduction for contributions of the

taxpayers services and rent-free use of the
taxpayers property
Out-of-pocket costs incurred for volunteer
work for a qualifying charity are deductible
Property other than long-term capital gain
property is valued at lesser of FMV or basis

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 Contributions of LTCG Property

LTCG property is valued at FMV (which is usually

greater than adjusted basis)
Tangible personalty given to a charity which does
not use the property in its tax-exempt activity is
valued at the lower adjusted basis
Deduction for LTCG property valued at FMV is
limited to 30% of AGI
30% limit can be avoided (and 50% AGI limit
applied) if taxpayer elects to use lower basis
If made, election applies to all LTCG contributions
that year
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 Charitable Contributions

Stocks or other income producing property

that have declined in value should be sold so
that the loss can be claimed with the sale
proceeds donated
Fees incurred for appraisals of donated
property may be deducted as a
miscellaneous itemized deductions

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 Casualty and Theft Losses

Loss is the lesser of

Assets adjusted basis or
Decline in assets fair market value as a result
of the casualty
Loss is reduced for any insurance proceeds
received
$100 floor applies to each casualty
Deductible only to extent total losses exceed
10% of AGI

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 Miscellaneous Deductions

Only excess over 2% of 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

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 Phaseout of
Itemized Deductions
Totaldeductions phased out by 3% of AGI in
excess of $142,700 in 2004 ($71,350 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

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 Tax Rates for
Married Filing a Joint Return
For married filing a joint return for 2004
10% on first $14,300 taxable income
15% on $14,301 - $58,100
25% on $58,101 - $117,250
28% on $117,251 - $178,650
33% on $178,651 - $319,100
35% over $319,100

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 Tax Rates for
Married Filing Separately
For married filing separately for 2004
10% on first $7,150 taxable income
15% on $7,151 - $29,050
25% on $29,051 - $58,625
28% on $58,626 - $89,325
33% on $89,326 - $159,550
35% over $159,551

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 Tax Rates for Single Individuals
For single individuals for 2004
10% on first $7,150 taxable income
15% on $7,151 - $29,050
25% on $29,051 - $70,350
28% on $70,351 - $146,750
33% on $146,751 - $319,100
35% over $319,100

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 Tax Rates for Head of Household
For head of household for 2004
10% on first $10,200 taxable income
15% on $10,201 - $38,900
25% on $38,901 - $100,500
28% on $100,501 - $162,700
33% on $162,701 - $319,100
35% over $319,100

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 Special Tax Rates

28% rate applies to LTCG from collectibles and

Section 1202 small business stock
25% rate applies to unrecaptured Section 1250
gain
15% rate on LTCG from the sale of capital assets
(applies to taxpayers in higher tax brackets)
5% rate applies to taxpayers in 10% or 15% tax
brackets
Dividend income is taxed using the capital gain
rate of 15% (5% for low-income taxpayers)
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 Credits vs. Deductions

Deductions only reduce tax liability by a

percentage based on the taxpayers
marginal tax rate
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 brackets

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 Child Tax Credit

$1,000 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 MFS)
$75,000 if single or head of household

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 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
2004)
A student who is a dependent cannot claim the
credit
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 Education Credits

Expenses paid with a Pell Grant,

scholarship, or employer-provided
educational assistance do not qualify
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
$42,000 - $52,000 if single
$85,000 - $105,000 if married filing jointly

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 Earned Income Credit

The purpose is 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
$2,604 ($7,660 x 34%)
With two or more qualifying children maximum
credit is $4,300 ($10,750 x 40%)
Smaller credit available to taxpayers without
children

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 Earned Income Credit

This is a refundable credit

Taxpayers with investment income of $2,650 or
more are not eligible
Anyone who can be claimed as a dependent is
not eligible
A taxpayer without a qualifying child, must be
between the ages of 25 through 64 to be eligible

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 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 under 13
35% if AGI does not exceed $15,000
Reduced by 1% for each $2,000 (or fraction
thereof) AGI exceeds $15,000
20% if AGI exceeds $43,000

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 Retirement Contributions Credit

To encourage participation by low-income

wage earners, a credit for up to $2,000
contributed to employer-sponsored retirement
plans or IRAs is available
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
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 Excess Payroll Tax Credit

Taxpayers working for more than one

employer during the year with earnings
exceeding the Social Security ceiling
($87,900 for 2004) usually have too much tax
withheld
Employee is allowed a credit for any excess
Social Security taxes withheld

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 Alternative Minimum Tax

The purpose of the alternative minimum tax is

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 AMT
IF AMT is greater than the regular tax,
taxpayers pay the larger amount
Rate is 26% on first $175,000 and 28% on
excess for individuals

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 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
Equals: Tentative minimum tax (TMT)
Less: Regular income tax
Equals: AMT

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 AMT Exemptions

AMT exemptions for 2004 are

$58,000 if married filing jointly
$29,000 if married filing separately
$40,250 if single or head of household

Exemptions begin to phase out when AMTI

reaches $112,500 for singles and $150,000 for
married filing jointly ($75,000 if MFS) at a rate of
$1 for every $4 above the threshold

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 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
deductible
Tax preferences that are added include
Nontaxable interest on private activity bonds
Bargain element of incentive stock options

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 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 payments are not 90% or more of the total
tax owed (or an amount required based on
the prior years tax), a penalty may be
charged, unless balance due is less than
$1,000

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 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
$7,950 in 2004 for a single individual
Returns should be filed if
Net self-employment income is $400 or more
A child claimed as a dependent has unearned
income only of over $800
Any married person filing separately has
income over $3,100

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 The End

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