Tax Ch 2 notes

Tax Formula for individuals:

Income from source derived
Minus: Exclusions
-------------------
Gross Income
Minus: Deductions for adjusted gross income
-------------------
Adjusted gross income
Minus: Deductions from adjusted gross income:
Greater of itemized deductions or the standard deduction
Personal or dependency exemptions
----------------------
Taxable income
Times: Tax rate/rates
--------------------
Gross tax
Minus: Credits and prepayments
-----------------
Net tax payable or refund due

Income: includes both taxable and non taxable income (income from any source)

• Differs from revenue because it doesn’t include “return of capital” (ie in sale of property,
only gain is viewed as income; in inventory sale, gross profit = income)

Exclusion: any item of income that tax law states is not taxable (see table I:2-2 pg 2-3 in txt)

• Exclusion is source of income that is omitted from the tax base whereas deduction is
expense that is subtracted in arriving at taxable income; both have effect of reducing
taxable income

Gross income: income reduced by exclusions; income from taxable sources that is reported on
the return (excluded income need not be disclosed); Section 61a contains list of gross income
items: states “gross income is all income from whatever source derived; ie illegal income is still
taxable” (see txt pg 2-4 Table I:2-3)

• Deductions: allowable ones include business and investment expenses generally, along
with personal expenses that are specially for in IRC such as charity contributions

Adjusted gross income (AGI): measure of income that falls between gross income and taxable
income; used in many tax computations (ie used to est. floors for medical deduction and casualty
loss deduction and est. ceiling for charity contribution deduction)
 o Section 62 lists deductions for AGI (see Table I: 2-4 pg 2-5 in txt); any allowable
deduction not listed in Sec. 62 is deduction from AGI

• Two categories of deductions:

o Deduction for AGI: expenses connected with trade/business (ie alimony allowed)

o Deduction from AGI: personal expenses that Congress has chosen to allow

 Itemized deductions or standard deduction: taxpayers generally cannot

deduct personal expenses but Congress allows deduction of charity
contributions and medical expenses; also allowed to itemize expenses
related to production/collection of income, management of property held
for production of income; determination/collection/refund of any tax

• Can claim either itemized deductions or standard deduction;

usually the SD > ID

 Personal and dependency exemptions: personal exemption is generally

allowed for each taxpayer and his spouse + additional dependency
exemption allowed for each dependent; both PE’s and DE’s were $3650 in
2009 and $3,500 in 2008

Taxable income: adjusted gross income reduced by deductions from AGI; it is the amount of
income that is taxed

Tax credits: amounts that can be subtracted from gross tax to arrive at net tax due or refund due
and includes prepayments; 2 categories: (see Table I: 2-5 in pg 2-6)

• Refundable tax credit: allowed to reduce taxpayer’s tax liability to zero and, if credit
remains, are refundable (paid) by govt. to the taxpayer; prepayments of tax are classified
here

• Nonrefundable tax credit: allowances created by Congress for various social, economic,
and political reasons such as child and dependent care credits; can be subtracted from tax
to reduce tax liability to zero but none of excess will be paid to taxpayer

Deductions from AGI

Itemized deductions: claimed only if total expenses exceeds standard deduction

• Deductible items: Congress allows itemizing specified personal expenses such as

medical, taxes, investment and residential interest, charity contributions, casualty and
theft loss, employee expenses (see table I:2-6 pg 2-10)

• Itemized deduction floors: 4 AGI floors associated with itemized deductions; AGI floors
represent amounts subtracted from deductions in arriving at allowable amounts; 3 floors
 apply to specific categories of itemized deductions and other floor applies to total
itemized deductions

o Medical expenses: only medical expenses over 7.5% of AGI are deductible

o Casualty losses: only those is excess of 10% of AGI are deductible

o Miscellaneous itemized deductions: only those in excess of 2% of AGI are

deductible

o High income taxpayers: temporary rule requires higher income taxpayers to

reduce total itemized deductions by 1% of their AGI in excess of $166,800 in
2009 ($83,400 for married filing separately); this reduction will be eliminated in
2010

Standard deduction: amount set by Congress which varies from year to year depending on
taxpayer’s filing status, age, and vision

Filing Status Standard Deduction

2008 2009

Single indiv. other than head of household $5,450 $5,700

Married couples filing joint returns and surviving spouses 10,900 11,400

Married people filing separate returns 5,450 5,700

Heads of households 8,000 8,350

*Differences between 2008 and 2009 represent adjustments for increase in cost of living

• 2009: married taxpayer’s standard deduction is $1,100 (1050 in 2008) if he is elderly or

blind ($2,200 if elderly and blind) or has a spouse who is elderly or blind (max possible
increase of $4,400 for a married couple)

o Unmarried taxpayer is elderly or blind: his standard deduction is increased by

$1,400 ($2,800 if elderly and blind). Thus a single taxpayer aged 65 and not blind
is entitled to $7,100 (5700 + 1400) standard deduction

o Two rules for age/blindness:

 Increase in standard deduction for elderly taxpayers is available if TP

turns 65 during the tax year; considered to be 65 on the day before
birthday (ie TP who reaches age 65 on Jan 1 of a year is deemed to have
reached 65 on Dec 31 of the preceding year); adjustment allowed on final
return of deceased TP only if he reached age 65 before death

 IRC defines blindness as corrected vision in the better eye of no better

than 20/200
• for most taxpayers, standard deduction is greater than total itemized deductions;
characteristics of taxpayers who itemize their deductions:

o high income taxpayers more likely to itemize than low income taxpayers because
more expenses incurred that can be itemized

o individuals who own homes and incur home mortgage expenses and property
taxes (these expenses are deductible and often alone exceed the standard
deduction)

• Temporary increase in Standard Deduction for Property Tax: taxpayers may increase
their standard deduction by the amt of state and local real property tax property taxes they
pay up to $500 ($1000 on a joint return)

• Loss of standard deduction: standard deduction unavailable to three categories of

taxpayers: 1) individual filing a return for a period less than 12 months because of change
in accounting period; 2) married taxpayer filing separate return in instances where the
other spouse itemizes; 3) nonresident aliens

• Limitation on standard deduction: special rule applies to individual for whom the
dependency exemption is allowable to another taxpayer. SD is limited to greater of 1)
dependent’s earned income plus $300 or 2) $950

Personal Exemptions: only one PE is allowed for each person. Almost every individual
taxpayer is allowed personal exemption of $3650; on joint return filed by married couple
allowed 2 personal exemptions. If married person files a separate return, taxpayer can claim
personal exemption for his spouse if spouse has no gross income during the year + spouse is
not the dependent of another taxpayer

Dependency Exemptions: taxpayers can claim dependency exemption for each dependent;
individual must be either 1) qualifying child or 2) qualifying relative to be a dependent. All
dependents must:

1) have an ID number (ie SSN)

2) be US citizens, nationals, or residents of US, Canada, or Mexico for part of yr

3) meet a separate return test: married dependents cannot file joint returns but a taxpayer
is entitled to exemption if dependent files joint return solely to claim refund of tax
withheld

4) not claim another person as a dependent: dependents who file tax returns may not
claim personal or dependency exemptions on their returns

• Additional requirements for qualifying child: to claim dependency exemption for

qualifying child, following must also be met:
 1) Relationship test: eligible children include taxpayer’s children (natural, adopted, foster,
stepchildren) and TP’s siblings (half and step), along with descendents of the above.

2) Age test: qualifying child must be under 19, full time student under 24, or permanently
and totally disabled child. A child is considered a student if he is in full time attendance
at educational institution for at least 5 months/year

3) Abode test: qualifying child must have same principal abode as taxpayer for more than
half the year

4) Support test: qualifying child may not provide more than half his own support during the
year (no requirement that taxpayer provide more than half the qualifying child’s support)

• Requirements for other relatives: dependency exemption may also be claim for qualifying
relative; dependents must meet requirements above + additional req:

1) Relationship test: other relatives must be related to TP or reside in TP’s household

for entire year; relatives who can be claimed as dependents without living with TP
include TP’s parents and their ancestors/siblings, stepparents, and in laws (mother, father,
brother sister, son, daughter only) + qualifying children

2) Gross income test: dependent’s gross income must be less than exemption amount
for the year ($3650 in 2009) (salary, taxable interest, rent considerednontaxable
scholarships, tax exempt bond interest, nontaxable SS benefits not considered)

3) Support test: taxpayer must normally provide more than half the dependent’s
financial support during the year (includes welfare and SS benefits spent on support even
if they are excluded from gross income)

• Tie breaker rule for dependency exemption: more than one person can meet requirements
to claim someone as a dependent; tiebreaker works as follows:

1) taxpayers who meet the requirements to claim the dependent under the qualifying
child rules have priority over individuals who meet the requirements for other relatives

2) Next priority goes to parents over others

3) If neither of the first 2 tiebreakers apply, exemption is awarded to taxpayer with

highest AGI (in case of parents, exemption awarded to parent with whom child resided
for longer time during the year; if equal amount of time was spent, then parent with
higher AGI gets exemption)

Two provisions override normal operation of dependency exemption rules:

1) Multiple Support Declaration (Form 2120): enables TP to claim dependency exemption

even if TP doesn’t provide over half the dependent’s support
 2) Release of Claim to Exemption for Child of Divorced/Separated Parents (Form 8332):
enables noncustodial parent to claim exemption

• Multiple Support Agreements: when a group provides over half the support of an
individual but no one member of the group provides over half the support, eligible
members of the group are allowed to designate one member to claim the exemption; TP
claiming the exemption must compete a Multiple Support Declaration (Form 2120). An
eligible member is one who contributes more than 10% of the dependent’s support and
meets all requirements for claiming dependency exemption except support requirement

o Multiple Support Declaration can supercede tiebreaker rules except that

agreement cannot be used to pass the exemption from a person who is entitled to
claim it under the qualifying child rules to someone who is entitled to claim the
exemption under the other dependent’s rule

• Parental release: in case of divorced or separated parents, dependency exemption is

generally awarded to custodial parent. But non-custodial parent may claim dependency
exemption if divorce agreement states it or if custodial parent agrees in writing

• Phase-out of personal and dependency exemptions: these exemptions are reduced for
high income taxpayers and but starting in 2010, high income taxpayers will receive full
amounts of these exemptions

o Exemptions are phased out at a rate of 2% for each $2500 ($1250 for married
persons filing separately) or fraction thereof of AGI above the following
thresholds:

 Single: $166,800

 Joint return 250,200

 Head of household 208,500

 Married filing separately 125,100

Child Credit: individual TP can claim “child credit” of $1000 for each qualifying child and is
reduced by $50 for each $1000 for which the TP’s modified AGI exceeds the following
thresholds: 1) $110,000 for joint returns; 2) $75,000 for single TP, 3) $55,000 for married
persons filing separately. To qualify for a credit, a child must be under 17 yrs old and be
“qualifying child”

- modified AGI = AGI + any amounts excluded from gross income under Secs. 911,
931, 933 which relate to certain foreign earned income and possession’s income

Making Work Pay Credit: new refundable credit equal to the lesser of:
 1) 6.2% of TP’s earned income or

2) $400 (800 for married filing joint return)

But the credit is reduced by 2% of the TP’s modified AGI that exceeds $75,000 ($150,000
for joint filers); $400 credit is completely phased out at modified AGI of $95,000; $800
credit phased out at $190,000

Determining the Amount of Tax

Filing Status: 6 tax brackets applicable to individual TPs: 10%, 15, 25, 28, 33, 35%; income lvl
at which individual is taxed depends on 5 different filing statuses: (4 schedules/tax tables since
MFJ and certain surviving spouse use same schedule/tax table)

1) Married filing jointly: joint return can be filed if criteria met:

o must be legally married as of last day of tax year; couples in process of divorce
are considered married until divorce date is final. Couples do not need to live
together to file jointly. Joint return can be filed if one spouse dies during the year
as long as survive doesn’t remarry before year end

o Must have same tax year end (except in case of death)

o Both husband and wife must be US citizens or residents. An exception allows

joint return if nonresident alien spouse agrees to report all his income on the
return

2) Surviving spouse

3) Head of Household

4) Single

5) Married filing separately