Exam 1 Study Guide

Chapter 3

3-1 Tax Formula

Components of the Tax Formula
● Income (Broadly Defined)
o In the tax formula, “income” is broadly defined and includes all of the taxpayer’s
income, both taxable and nontaxable.
o In general, the courts have defined “income” as any increase in wealth
▪ Does not include a return of capital or borrowed funds
● Exclusions
o Chart on Page 4 Exhibit 3-1
● Gross Income
o The Internal Revenue Code defines gross income broadly as “except as otherwise
provided…, all income from whatever source derived
o Gross income does not include unrealized gains (e.g. stock that has appreciated in
value but has not been sold)
● Deductions for Adjusted Gross Income
o Sometimes called above-the-line deductions because on the tax return, they are
taken before the “line’ designating AGI
o Deductions for AGI include, but are not limited to, the following
▪ Trade or business expenses
▪ Part of the self-employment tax
▪ Contributions to traditional Individual Retirement Accounts (IRAs) and
other retirement plans
▪ Contributions to Health Savings Accounts (HSAs)
▪ Interest on student loans
▪ Excess capital losses
▪ Certain alimony payments
● Deductions from Adjusted Gross Income
o Personal expenses are not allowed as deductions in computing taxable income
o Congress allows some personal expenses as deductions from AGI which are
called itemized deductions
● Nondeductible Expenses
o Personal living expenses
o Employee business expenses (unless reimbursed by employer)
o Most investment expenses (e.g., investment counsel fees, safe deposit box rental,
and publications)
o Tax return preparation fees
o Losses on the sale of personal use property (e.g., the furniture you own)
 o Hobby expenses
o Life insurance premiums
o Gambling losses (in excess of gains)
o Child support payments
o Fines and penalties
o Political contributions
o Funeral expenses
o Capital expenditures
● Standard Deduction
o Instead of claiming itemized deductions, taxpayers can use the standard deduction
● Personal and Dependency Exemptions
o Prior to 2018, exemption deductions were allowed for the taxpayer, the taxpayer’s
spouse, and each dependent of the tax payer
o Exemption deductions are suspended from 2018 through 2025
● Deduction for Qualified Business Income
o From 2018 through 2025, a deduction for qualified business income is allowed
o The deduction allowed is the lesser of
▪ 20% of qualified business income
▪ 20% of modified taxable income
● Tax Due (or Refund)
o Tax rates are applied to taxable income to determine the tax liability
o Once the tax is computed, the amount is reduced by any taxes withheld and tax
credits allowed to arrive at the additional tax due or overpayment

Tax Formula – Correlation with Form 1040

● Exhibit 3-4 Page 8
● Homework Problems 27, 47

3-2 Standard Deduction

Basic and Additional Standard Deduction
● Standard deduction is the sum of two components
o The basic standard deduction
o Additional standard deduction
● Taxpayer who is age 65 or over or blind qualifies for an additional standard deduction of
$1,300 or $1,650 depending on filing status
● To determine whether to itemize, the taxpayer compares the total standard deduction with
total itemized deductions
● Taxpayers are allowed to deduct the greater of itemized deductions or the standard
deduction
● Taxpayer’s age also makes a difference
Individuals Not Eligible for the Standard Deduction
● Some individuals are not allowed to use the standard deduction. The following individual
taxpayers must itemize their deductions
o A married individual filing a separate return where either spouse itemizes
deductions
o A nonresident alien (an individual who is neither a U.S. citizen nor a U.S.
resident)
● If an individual dies during a year, a full standard deduction is available for the final tax
return; deduction is not reduced because the return only covers a portion of the calendar
year

Special Limitations on the Standard Deduction for Dependents

● Special rules apply to the standard deduction of an individual who can be claimed as a
dependent on another person’s tax return
o A dependent’s basic standard deduction is limited to the greater of $1,100 or the
sum of the individual’s earned income for the year plus $350
o If the sum of the individual’s earned income plus $350 exceeds the basic standard
deduction is used
● Homework Problem 30

3-3 Exemptions
● Two types of exemptions have been allowed
o Personal exemptions
o Dependency exemptions
● Exemption deduction has been suspended in 2018 through 2025
● Homework Problems 32, 45, 47

3-4 Dependents
Qualifying Child
● Relationship Test
o Includes a taxpayer’s child, adopted child, stepchild, eligible foster child, brother,
sister, half-brother, half-sister, stepbrother, stepsister, or a descendant of any of
these parties (grandkid, nephew, niece)
o Ancestors of any of these parties (uncles and aunts) and in-laws are not included
o An adopted child includes a child placed with the taxpayer even though the
adoption is not final
o An eligible foster child is a child who is placed with the taxpayer by an authorized
placement agency or by a court order
 ● Residence Test
o A qualifying child must live with the taxpayer for more than half of the year
o Temporary absences are ignored (school, vacation, medical care, military service,
juvenile facility, etc.) are ignored
● Age Test
o A qualifying child must, by the end of the tax year, by
▪ Under 19
▪ Under 24 and a full-time student (in school during any part of five months
of the year)
o Age test does not apply to a child who is disabled during any part of the year
o Qualifying child must be younger than the taxpayer claiming him or her (brother
can’t claim older sister as a QC)
● Support Test
o To be a qualifying child, the individual must be self-supporting (provide more
than half of his or own support)
▪ Support includes food, shelter, clothing, toys, medical and dental care,
education and similar items
o A child who is a full time student, scholarships are not considered support
● Tiebreaker Rules
o In some situations, a child may be a qualifying child to more than one person
o These include
▪ One of the persons is the parent = Parent
▪ Both person are the parents, and the child lives longer with one parent
= parent with the longer period of residence
▪ Both persons are the parents, and the child lives with each the same period
of time = parent with the higher AGI
▪ None of the persons is the parent = person with highest AGI

Qualifying Relative
● Relationship Test
o Includes parents, grandparents, uncles, aunts, son in law, daughter in law, father
in law, mother in law, brother in law, and sister in law
o Live with the taxpayer for the entire year and they can be related or unrelated
● Gross Income Test
o Dependent’s gross income must be less than the exemption amount – $4,200
● Support Test
o Taxpayer must furnish over half of the qualifying relative’s support
 ● Exceptions to the support test
o Multiple Support Agreements
▪ A multiple support agreement allows a group of taxpayers – none of
whom provide more than 50 percent of the support of a taxpayer – to
designate one member of the group to claim the individual as a dependent
▪ Collectively, the group must provide more than 50 percent of the support
▪ Any person who contributed more than 10 percent of the support is
entitled to claim the individual as a dependent
▪ The person designated to claim the individual as a dependent under a
multiple support agreement must meet all other dependency requirements
o Children of Divorced or Separated Parents
▪ Unmarried parents living apart for the last 6 months of the year are also
covered by these rules
▪ This exception applies if the parents meet the following conditions
● They would have been entitled to claim the individual(s) as a
dependent had they been married and filed a joint return
● They have custody (either jointly or singly) of the child (or
children) for more than half of the year
▪ The parent having custody of the child (children) for the greater part of the
year is entitled to claim the dependent
● Custodial parent can sign a waiver that allows the noncustodial
parent to claim the child as a dependent (Form 8332)

Other Rules for Determining Dependents

● Joint Return Test
o If a dependent is married, the supporting taxpayer generally is not permitted to
claim that individual as a dependent if the married individual files a joint return
with his or her spouse
o The joint return rule does not apply, however if the reason for filing is to claim a
refund for tax withheld
● Citizenship Test
o Individual must be a U.S. citizen or a U.S. resident
o Under an exception, an adopted child need not be a citizen or resident of the
United States as long as his or her principal residence is with a U.S. citizen

Child and Dependent Tax Credits

● Child tax credit and dependent tax credit are provided to individual taxpayers based on
the number of their qualifying children and dependents
● From 2018 to 2025, Congress increased the amount of the child tax credit and created a
dependent tax credit
● $2,000 child tax credit
 o Allowed for each qualifying child (including stepchildren and foster children)
o To be eligible for this credit, the child must:
▪ Be under 17
▪ Must be a U.S. citizen
▪ Must be a dependent of the taxpayer
▪ Social security number must be provided for any qualifying child
● $500 tax credit is allowed for each dependent of the taxpayer
o Examples of qualifying relatives for purposes of the dependent tax credit include:
▪ Children over age 16
▪ Children without a social security number
▪ Parents of the taxpayer
▪ Members of the household
o For purposes of the dependent tax credit, these qualifying relatives must be a U.S.
citizen, a U.S. national, or a U.S. resident
● Child and Dependent Tax Credits Phase-out
o The available child and dependent tax credits begin to phase out when AGI
reaches $400,000 for married taxpayers filing jointly ($200,000 for all other
taxpayers)
o Maximum credit amount depends on the number of qualifying children and
dependents, the income level at which these credits are phased out completely
also depends on the number of qualifying children and dependents
o If married taxpayers filing a joint return have one qualifying child, the child tax
credit is completely phased out if their AGI exceeds $440,000
o If those taxpayers have two qualifying children, the child tax credit is completely
phased out if their AGI exceeds $480,000
o For all other taxpayers, these amounts would be $240,000 and $280,000,
respectively
o The allowed tax credit can be determined using the following steps:
▪ AGI – Threshold amount = Excess amount
▪ Excess amount / $1,000 = Reduction factor
▪ Reduction factor X 50 = child and dependent tax credit reduction
▪ Maximum child and dependent tax credit amount – child and dependent
tax credit reduction = child and dependent tax credit allowed
● Refundable Portion of Child Tax Credit
o For all taxpayers with qualifying children, the child tax credit is refundable to the
extent of the lesser of :
▪ $1,400 of the child tax credit for each qualifying child
▪ 15 percent of the taxpayer’s earned income in excess of $2,500
o If a taxpayer has three or more qualifying children, an alternative formula is
available to determine the refundable portion
▪ Refundable portion is equal to the amount by which a taxpayer’s Social
Security taxes exceed the earned income tax credit
 ● Homework Problems 32, 35, 45

3-5 Filing Status and Filing Requirements

Filing Status
● Taxpayer’s filing status is important because it is used to determine:
o The taxpayer’s standard deduction
o Whether the taxpayer must file a tax return
o The taxpayer’s tax liability; reduction of itemized deductions and certain tax
credits
o Eligibility for certain provisions
● Single taxpayers
o A taxpayer who is unmarried (including a taxpayer who is legally separated or
divorced) and does not qualify for head-of-household status will file as a single
taxpayer
● Married taxpayers
o Married couples can file tax returns together (married, filing jointly) or apart
(married filing separately)
o Marital status is determined on the last day of the year
o When one spouse dies during the year, the surviving spouse is considered to be
married to the spouse who died at the end of the year
▪ Married Filing Separately
● Limitations on married persons who file separately include:
o If either spouse itemizes deductions, the other spouse must
also itemize
o The earned income credit and the credit for child and
dependent care expenses cannot be claimed
o No deduction is allowed for interest paid on qualified
education loans
o Only $1,500 of excess capital losses can be claimed by
each spouse
▪ Surviving Spouse
● Joint filing status also applies for two years following the death of
one spouse if the surviving spouse maintains a household for a
dependent child
● Child must be a son, stepson, daughter, or stepdaughter who
qualifies as a dependent of the taxpayer
▪ Marriage Penalty
● Occurs when both spouses have substantial income
 ● Head of Household
o Unmarried individuals who maintain a household for a dependent can use the
head-of-household filing status
o The tax liability using the head-of-household rates falls between the tax liabilities
for married taxpayers filing jointly and single taxpayers
o To qualify for the head-of-household filing status, a tax payer must:
▪ Pay more than half the cost of maintain a household as his or her home
▪ Household must also be the principal home of a dependent except for
temporary absences
▪ Dependent must live in the taxpayer’s household for over half the year
▪ Dependent must be either a QC or a QR who meets the relationship test
● Abandoned Spouse Rules
o Taxpayer is treated as not married and qualifies for head-of-household status if
the following conditions are met:
▪ The taxpayer does not file a joint return
▪ The taxpayer paid more than half the cost of maintain his or her home for
the tax year
▪ The taxpayer’s spouse did not live in the home during the last six months
of the tax year
▪ The home was the principal residence of the taxpayer’s son, daughter,
stepson, stepdaughter, foster child, or adopted child for more than half the
year and the child can be claimed as a dependent

Filing Requirements
● General rules
o An individual must file a tax return if gross income equals or exceeds the
applicable standard deduction
o A married taxpayer filing a separate return is required to file a return if he or she
reports an amount of gross income
o Standard deduction amounts are subject to an annual inflation adjustment
o Additional standard deduction for being age 65 or older is considered in
determining the gross income filing requirements
o A self-employed individual with net earnings of $400 or more from a business or
profession must file a tax return regardless of the amount of gross income
o Even though an individual has gross income below the filing level amounts and
therefore does not owe any tax, her or she must file a return to obtain tax refund
of amounts withheld
 ● Filing Requirements for Dependents
o A dependent must file a return if he or she has any of the following
▪ Earned income only and gross income that is more than the total standard
deduction
▪ Unearned income only and gross income of more than $1,100 plus any
additional standard deduction
▪ Both earned and unearned income and gross income of more than the
larger of $1,100 or the sum of earned income plus $350 plus any
additional standard deduction
● Homework Problems 41, 43, 45

3-6c Kiddie Tax – Unearned Income of Dependent Children

● Kiddie tax applied to any child who is under age 19 or under 24 if a full-time student and
has unearned income of more than $2,200
● Net Unearned Income
o Unearned income
o Less: $1,100
o Less: the greater of
▪ $1,100 of the standard deduction or
▪ The amount of allowable itemized deductions directly connected with the
production of the unearned income
o Equals: Net Unearned Income
● Tax Determination when Net Unearned Income exists
o If a child is subject to the “kiddie tax”, the tax computation depends on
▪ Whether the child has any earned income
▪ The child’s taxable income
o Child tax is 10% of taxable income if the child has no earned income and no more
than $3,700 of taxable income
o For all other children, a single tax rate schedule is used
▪ Earned taxable income + 2,600
▪ Net unearned income – 2,600
● Homework Problem 47

3-8 Gains and Losses from Property Transactions – In

General
● When property is sold, a gain or loss results
● The gain or loss has a tax effect on the seller when the realized gain or loss is recognized
for tax purposes
 ● Adjusted basis of the property is determined as follows:
o Cost
o Add: capital additions
o Subtract: depreciation and other capital recoveries
o Equals: adjusted basis at date of sale or other disposition
● All realized gains are taxable
● Realized losses from the sale of personal use property (a residence, home furnishings,
clothing, sports equipment) are not recognized
● Homework Problem 48

3-9 Gains and Losses from Property Transactions – Capital

Gains and Losses
Definition of Capital Asset
● Capital assets are defined in the Code as any property held by the taxpayer other than
certain items including inventory, accounts receivable, and depreciable property or real
estate used in a business

Determination of Net Capital Gain

● To arrive at a net capital gain, capital losses must be taken into account
● First, capital gains and losses are categorized based on their holding period: short-term
and long-term
● If excess losses result, they are applied to the category carrying the highest tax rate
● A net capital gain occurs if the net long-term capital gain exceeds the net short-term
capital loss

Treatment of Net Capital Loss

● For individual taxpayers, net capital loss can be used to offset ordinary income of up to
$3,000 ($1,500 for married persons filing separate returns)
● Short-term losses are used first
● Any remaining net capital loss is carried over indefinitely until used up

Taxation of Net Capital Gain

● Short-term gains = 37% max rate
● Long-term gains = 28% max rate
● Certain depreciable property = 25% max rate
● All other long-term capital gains = 20%, 15%, or 0%
Chapter 13

13-4 Other Tax Credits

Earned Income Credit
● The earned income credit provides income tax equity to the working poor
● The credit also helps to offset other Federal taxes, such as the gasoline tax, that impose a
relatively larger burden on low-income taxpayers
● The credit encourages economically disadvantaged individuals to become contributing
members of the workforce
● To determine the earned income credit, take the credit percentage based on how many
QC’s and multiply it by the earned income base amount
● Eligibility Requirements
o Eligibility for the credit may depend not only on the taxpayer meeting the earned
income and AGI thresholds, but also on whether he or she has a qualifying child
o In addition to being available for taxpayers with qualifying children, the earned
income credit is also available to certain workers without children
▪ It is available only to taxpayers ages 25 through 64 who can’t be claimed
as a dependent on another taxpayer’s return

Child and Dependent Tax Credits

● A child tax credit and a dependent tax credit are provided to individual taxpayers based
on the number of their qualifying children and dependents
● To be eligible for the child tax credit, the child must be
o Under age 17
o A U.S. citizen
o Dependent of the taxpayer
● The child tax credit is $2,000 per child and the dependent tax credit is $500 per non-child
dependent
● The credits phase out as AGI exceeds $400,000 (married filing jointly) or $200,000
(other taxpayers)
● The child tax credit is partially refundable (up to $1,400 per child, but no more than 15
percent of earned income in excess of $2,500)
● The dependent tax credit is not refundable

Credit for Child and Dependent Care Expenses

● The credit for child and dependent care expenses mitigates the inequity felt by working
taxpayers who must pay for child care services to work outside the home
● The credit is a specified percentage of child and dependent care expenses
● The credit percentage varies based on the taxpayer’s AGI, and expenses are capped at a
maximum of $6,000
● Eligibility
 o To be eligible for the credit, an individual must either
▪ A dependent under age 13 or
▪ A dependent or spouse who is physically or mentally incapacitated and
who lives with the taxpayer for more than one-half of the year
▪ Generally, married taxpayers must file a joint return to obtain the credit
● Eligibility Employment-Related Expenses
o Eligible expenses include amounts paid for household services and care of a
qualifying individual that are incurred to enable the taxpayer to be employed
o The care can be provided in the home (e.g., by a nanny) or outside the home (e.g.,
at a day-care center)
o Out-of-the-home expenses incurred for an older dependent or spouse who is
physically or mentally incapacitated qualify for the credit if that person regularly
spends at least eight hours each day in the taxpayer’s household. This makes the
credit available to taxpayers who keep handicapped older children and elderly
relatives in the home instead of institutionalizing them.
o Child care payments to a relative are eligible for the credit unless the relative is a
child (under age 19) of the taxpayer.
● Earned Income Ceiling
o Qualifying employment-related expenses are limited to an individual’s earned
income
o For married taxpayers, this limitation applies to the spouse with the lesser amount
of earned income
o Special rules are provided for taxpayers with nonworking spouses who are
disabled or are full-time students
▪ Here, the nonworking spouse is deemed to have earned income of $250
per month if there is one qualifying individual in the household or
▪ $500 per month if there are two or more qualifying individuals in the
household.
▪ In the case of a student-spouse, only months when the student is enrolled
on a full-time basis are counted
● Calculation of the Credit
o In general, the credit is equal to a percentage of unreimbursed employment-
related expenses up to $3,000 for one qualifying individual and$6,000 for two or
more individuals
o The credit rate varies between 20 percent and 35 percent, depending on the
taxpayer’s AGI
● Dependent Care Assistance Program
o A taxpayer is allowed an exclusion from gross income for a limited amount of
employer- reimbursed child or dependent care expenses
o If this occurs, the $3,000 and $6,000 ceilings for allowable child and dependent
care expenses are reduced dollar for dollar by the amount of the employer’s
reimbursement
Education Tax Credits
● The American Opportunity credit and the lifetime learning credit are available to help
qualifying low- and middle-income individuals defray the cost of higher education
● The credits are available for qualifying tuition and related expenses incurred by students
pursuing undergraduate or graduate degrees or vocational training
● Books and other course materials are eligible for the American Opportunity credit (but
not the lifetime learning credit)
● Room and board are ineligible for both credits
● Maximum Credit
o The American Opportunity credit permits a maximum credit of $2,500 per year
(100 percent of the first $2,000 of tuition expenses plus 25 percent of the next
$2,000 of tuition expenses) for the first four years of postsecondary education
o The lifetime learning credit permits a credit of 20 percent of qualifying expenses
(up to $10,000 per year) incurred in a year in which the American Opportunity
credit is not claimed
o Generally, the lifetime learning credit is used for individuals who are beyond the
first four years of postsecondary education
● Eligible individuals
o Both education credits are available for qualified expenses incurred by a taxpayer,
taxpayer’s spouse, or taxpayer’s dependent
o The American Opportunity credit is available per eligible student, while the
lifetime learning credit is calculated per taxpayer
o To be eligible for the American Opportunity credit, a student must take at least
one-half the full-time course load for at least one academic term at a qualifying
educational institution
o No comparable requirement exists for the lifetime learning credit
o So taxpayers who are seeking new job skills or maintaining existing skills through
graduate training or continuing education are eligible for the lifetime learning
credit
o Taxpayers who are married must file a joint return to claim either education credit
● Income Limitations and Refundability
o Both education credits are subject to income limitations, which differ by credit
▪ Forty percent of the American Opportunity credit is refundable, and it can
offset a taxpayer’s alternative minimum tax (AMT) liability
▪ The lifetime learning credit is neither refundable nor an AMT liability
offset
o The American Opportunity credit amount is phased out beginning when the
taxpayer’s AGI (modified for this purpose) reaches $80,000 ($160,000 for
married taxpayers filing jointly)
o The credit is phased out proportionally over a $10,000 ($20,000 for married
taxpayers filing jointly) phase-out range
 o As a result, the credit is eliminated when modified AGI reaches $90,000
($180,000 for married taxpayers filing jointly).
o The American Opportunity credit amount is phased out beginning when the
taxpayer’s AGI (modified for this purpose) reaches $80,000 ($160,000 for
married taxpayers filing jointly)
o The credit is phased out proportionally over a $10,000 ($20,000 for married
taxpayers filing jointly) phase-out range
o As a result, the credit is eliminated when modified AGI reaches $90,000
($180,000 for married taxpayers filing jointly)
● Restrictions on Double Tax Benefit
o Taxpayers who claim an education credit may not deduct the expenses nor may
they claim the credit for amounts that are otherwise excluded from gross income
(e.g., scholarships and employer-paid educational assistance)

Energy Credits
● The energy tax credits include incentives to:
o Install energy-efficient windows, insulation, and heating and cooling equipment;
o Purchase solar and other energy-efficient water heaters; and
o Install equipment in a business to produce electricity using solar, wind, or
geothermal sources

Credit for Certain Retirement Plan Contributions

● Taxpayers may claim a nonrefundable credit for certain retirement plan
contributions based on eligible contributions of up to $2,000 to certain qualified
retirement plans, like traditional and Roth IRAs and § 401(k) plans.
● This credit, sometimes referred to as the “saver’s credit,” encourages lower- and middle-
income taxpayers to contribute to qualified retirement plans
● If a taxpayer (and/or spouse) contributes to and receives distributions from a qualifying
plan, these amounts must be netted
● Distributions in the tax year, in the two prior tax years, and during the period prior to the
due date of the return are used in this netting process
● The credit rate applied to the eligible contributions depends on the taxpayer’s AGI and
filing status
● However, the maximum credit allowed to an individual is $1,000 ($2,000 × 50%)
● Once AGI exceeds the upper end of the applicable range, no credit is available
● To qualify for the credit, the taxpayer must be at least 18 years of age and cannot be a
dependent of another taxpayer or a full-time student
● Homework problems 5, 19, 30, 33, 34, 35
13-5 Payment Procedures
● The tax law contains elaborate “pay-as-you-go” rules that require the prepayment of
various Federal taxes
● In addition, these rules carry penalties for any lack of compliance
● Prepayment procedures fall into two major categories:
o Those applicable to employers and those applicable to self-employed persons. For
employers, both payroll taxes (FICA and FUTA) and income taxes may be
involved.
o With self-employed taxpayers, the focus is on the income tax and the self-
employment tax.

Employers
● Employment taxes include FICA (Federal Insurance Contributions Act; commonly
known as Social Security) and FUTA (Federal Unemployment Tax Act)
● The employer usually is responsible for withholding the employee’s share of FICA and
appropriate amounts for income taxes
● In addition, the employer must match the FICA portion withheld and fully absorb the cost
of FUTA
● Employers are required to pay these amounts to the IRS on a regular basis (usually
weekly or monthly)
● The key to employer compliance in this area involves the following
o Identifying which employees and wages are covered by employment taxes and are
subject to withholding for income taxes
o Determining the amount to be paid and / or withheld
o Reporting and paying employment taxes and income taxes withheld to the IRS on
a timely basis through the use of proper forms and procedures
● Amount of FICA taxes
o The FICA tax has two components:
▪ Social Security tax (old age, survivors, and disability insurance) 
▪ Medicare tax (hospital insurance)
o The tax rates and wage base under FICA have increased substantially over the
years
o The base amount is adjusted each year for inflation
o The employer must match the employee’s portion, so the total Social Security tax
rate is 12.4 percent and the total Medicare tax rate is 2.9 percent
o Employee withholdings continue until the maximum base amount is reached
● Amount of Income Tax Withholding
o Three steps are used to determine the employee’s income tax withholdings
▪ Step 1: Have the employee complete Form W-4, Employee’s Withholding
Allowance Certificate
▪ Step 2: Determine the employee’s payroll period
 ▪ Step 3: Compute the amount to be withheld, usually using either the wage-
bracket tables or the percentage method
o Form W–4 reflects the employee’s marital status and withholding allowances
o Generally, this form need not be filed with the IRS and is retained by the
employer as part of its payroll records
o On the Form W–4, an employee may claim withholding allowances based on a
variety of factors, including what the filing status is, whether the child and
dependent tax credit is available, and whether the taxpayer will use the standard
deduction or itemize deductions
o To avoid having too little tax withheld, some employees may find it necessary to
reduce the number of withholding allowances.
o This might be the case for an employee who has more than one job or who has
other sources of income that are not subject to adequate withholding
o In addition, an employee can direct the employer to withhold a certain dollar
amount in addition to the required amount.
● Reporting and Payment Procedures
o Employers devote a significant amount of time and expense in complying with the
various employment tax and income tax withholding rules
o Among the Federal forms that must be filed are the following
▪ Form W–2 furnishes essential information to employees concerning wages
paid, FICA, and income tax withholdings.
● This form (reporting information for the previous calendar year)
must be furnished to an employee not later than January 31
● Employees then report the relevant amounts on the appropriate
lines of their Form 1040
● If the taxpayer itemizes deductions, amounts reported in boxes 17
and 19 (state and local income taxes, respectively) can be included
on line 5 of Schedule A (Form 1040)
● These amounts also typically are used on the state and/or local tax
return.
▪ Form 940 (or Form 940 EZ) is the employer’s annual accounting of its
FUTA liability
● Generally, it is due one month after the end of the calendar year
(i.e., no later than January 31, 2020, for the 2019 calendar year)
and must include any remaining FUTA due
o Employers make deposits of employment taxes, usually weekly or monthly, and
they pay any outstanding amounts at the end of every quarter, using Form 941
● Backup Withholding
o Some payments made to individuals by banks or businesses are subject to backup
withholding, to ensure that income tax is collected on interest income and other
payments reported on a Form 1099
 o Backup withholding is required if the taxpayer does not give his or her Social
Security number to the business or bank when required
o If backup withholding applies, the payor withholds 24 percent of the gross
amount

Self-Employed Tax Payers

● Estimated Tax for Individuals
o Estimated tax is the amount of tax (including AMT and self-employment tax) an
individual expects to owe for the year after subtracting tax credits and income tax
withheld
o Any individual who has estimated tax of $1,000 or more and whose withholding
does not equal or exceed the required annual payment (discussed below) must
make quarterly payments.
o If these payments are not made, a penalty may be assessed
o No quarterly payments are required (and no penalty will apply) if the taxpayer’s
estimated tax is under $1,000
o In addition, no penalty will apply if the taxpayer had a zero tax liability for the
prior tax year, provided the prior tax year was 12 months (i.e., not a short
year) and the taxpayer was a citizen or resident for that entire year
o The required annual payment must be computed first
o This is the smaller of the following amounts
▪ Ninety percent of the tax shown on the current year’s return.
▪ One hundred percent of the tax shown on the preceding year’s return (the
return must cover the full 12 months of the preceding year).
▪ If the AGI on the preceding year’s return exceeds $150,000 ($75,000 if
married filing separately), the 100 percent requirement is increased to 110
percent
o In general, one-fourth of this required annual payment is due on April 15, June
15, and September 15 of the tax year and January 15 of the following year
o An equal part of withholding is deemed paid on each due date
▪ So if $10,000 has been withheld during the year, $2,500 is applied to each
quarter
▪ If the quarterly estimates are determined to be
$3,000, then $500 ($3,000 − $2,500) must be paid each
quarter.
▪ Payments are submitted with the payment voucher for the appropriate
quarter from Form 1040–ES
● Penalty on Underpayments
o A nondeductible penalty is imposed on any estimated tax underpayment
o The penalty rate is adjusted quarterly to reflect changes in the average prime rate
o An underpayment occurs when any installment (the sum of estimated tax paid and
income tax withheld) is less than 25 percent of the required annual payment
 o The penalty is applied to the amount of the underpayment for the period of the
underpayment
o If a possible underpayment of estimated tax is indicated, Form 2210 is filed to
compute the penalty due or to justify that no penalty applies.
● Self-Employment Tax
o The tax on self-employment income is levied to provide Social Security and
Medicare benefits (old age, survivors, and disability insurance and hospital
insurance) for self-employed individuals.
o Individuals with net earnings of $400 or more from self-employment are subject
to the self-employment tax
o Net earnings from self-employment includes gross income from a trade or
business less allowable trade or business deductions, the distributive share of any
partnership income or loss derived from a trade or business activity, and net
income from rendering personal services as an independent contractor.
▪ This amount includes profits from sales of inventory
o Self-employed taxpayers are allowed a deduction from net earnings from self-
employment, at one-half of the self-employment rate, for purposes of determining
self-employment tax and an income tax deduction (normally, one-half of the self-
employment tax liability)
o If an individual also receives wages subject to the FICA tax, the ceiling amount of
the Social Security portion on which the self-employment tax is computed is
reduced
▪ However, a combination of FICA wages and self-employment earnings
will not reduce the Medicare component of the self-employment tax,
because there is no ceiling on this component of the tax.
● Homework problem 21

13-6 Affordable Care Act Provisions

Premium Tax Credit
● Individuals and families whose household incomes are at least 100 percent but no more
than 400 percent of the federal poverty level (also called the federal poverty line, or FPL)
may be eligible to receive a federal subsidy (the premium tax credit, or PTC) if they
purchase insurance via the Health Insurance Marketplace (the Marketplace)
● Individuals whose income exceeds 400% of the FPL are not eligible for a PTC
● For 2019 tax returns, the FPL for claiming a PTC is $12,140 ($12,490 for 2020) for a
single person (an additional $4,320 ($4,420 in 2020) is added to that amount for each
person in the household)
● Individuals can choose to receive their PTC in advance, and the Marketplace will send
the money directly to the insurer to reduce the monthly insurance payments
● Alternatively, individuals can receive the PTC as a refundable credit when they file their
tax return for the year
 ● Most individuals choose to receive their PTC in advance
o In either case, however, taxpayers will be required to complete Form 8962
(Premium Tax Credit) when their tax return is filed.
● Taxpayers who enrolled in health care coverage via the Marketplace will receive
information necessary to complete Form 8962 by the end of January each year
● Taxpayers who received the credit in advance must reconcile the credit based on actual
income that year with the amounts that were subsidized through the Marketplace
● They will receive a refund (if the advance credit was too low) or owe an additional tax
obligation (if the advance credit was too large)

Additional Medicare Taxes on High Income Individuals

● Additional Tax on Wages
o An additional 0.9 percent Medicare tax is imposed on wages received in excess of
$250,000 for married taxpayers filing a joint return ($125,000 if married filing
separately) and $200,000 for all other taxpayers
o Unlike the general 1.45 percent Medicare tax on wages, the additional tax on a
joint return is based on the combined wages of the employee and the employee’s
spouse
o The Medicare tax rate is:
▪ 1.45 percent on the first $200,000 of wages ($125,000 on a married filing
separate return; $250,000 of combined wages on a married filing joint
return), and
▪ 2.35 percent (1.45% + 0.9%) on wages in excess of $200,000 ($125,000
on a married filing separate return; $250,000 of combined wages on a
married filing joint return)
o Employers must withhold the additional 0.9 percent Medicare tax on wages paid
in excess of $200,000
o An employer is not responsible for determining wages earned by an employee’s
spouse
o The additional Medicare tax also applies to self-employed individuals—with net
earnings from self-employment being used for the threshold computations
o As a result, the tax rate for the Medicare tax on self-employment income will be:
▪ 2.9 percent on the first $200,000 of net earnings from self-employment
($125,000 on a married filing separate return; $250,000 on a married filing
joint return); and
▪ 3.8 percent (2.9% + 0.9%) on net earnings from self-employment in
excess of $200,000 ($125,000 on a married filing separate return;
$250,000 on a married filing joint return).
 o For married taxpayers, one of whom has wages and one of whom has self-
employment income, the thresholds are reduced (but not below zero) by the
amount of wages taken into account in determining the additional 0.9 percent
Medicare tax on wages
▪ Although self-employed individuals are allowed an income tax deduction
for part of the self-employment tax, this additional 0.9 percent Medicare
tax will not create a deduction 
● Additional Tax on Unearned Income
o An additional 3.8 percent Medicare tax is imposed on the unearned income of
individuals, estates, and trusts.
o Also known as the net investment income tax, the tax is 3.8 percent of the lesser
of:
▪ Net investment income or
▪ The excess of modified adjusted gross income over $250,000 for married
taxpayers filing a joint return ($125,000 if married filing separately) and
$200,000 for all other taxpayers
o In general, “net investment income” includes interest, dividends, annuities,
royalties, rents, income from passive activities, and net gains from the sale of
investment property less deductions allowed in generating that income
o Modified adjusted gross income (MAGI) is adjusted gross income (AGI)
increased by any foreign earned income exclusion
o For individuals who don’t incur any excluded foreign earned income, MAGI is
the same as AGI
o The 3.8 percent additional Medicare tax on unearned income is in addition to the
additional 0.9 percent Medicare tax on wages or self-employment income.
o Taxpayers who have either high wages (or self-employment income) and high
investment income may be subject to both taxes
● Homework problems 10, 23