Concepts in Federal Taxation 2015 22nd

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Instructor’s Manual
Ch 8: Taxation of Individuals

Chapter Taxation of Individuals

The conclusion of this chapter is a natural stopping-place for a one-quarter course. The
topics within this chapter cover those aspects of income taxation that are unique to
individuals. You may wish to spend as many as four 50-minute class periods on these
topics.

Teaching Tip #1: Integrative Problem 98 is the second half of the integrative problem
introduced at the end of Chapter 4 as Integrative Problem 86. In Problem 4-86 students
were asked to calculate the taxpayer’s gross income. In this second phase, Problem 98
provides additional information necessary for students to calculate taxable income, income
tax liability, and additional tax (or refund) due for 2014. The gross income items from
Problem 4-86 still apply.

Teaching Tip #2: Integrative Tax Return Problem 96 covers many of the issues of
individual taxation. It is a good summary for Chapters 1 to 8. It is also the final part of the
six part comprehensive tax return problem started in Chapter 3.

Writing Assignments: Problems 49, 51, 55, 58, 60, and 66; Integrative Problem 98);
Tax Planning Cases 101, 102, and 103; and Ethics Discussion Case 104 are the
suggested writing assignment problems within this chapter.

Free-Writing Assignment: To help students understand the differences between personal

and dependency exemptions and to help reinforce the rules for establishing dependency
the following has proved successful:

Jane O'Reilly is a staff accountant and earns $39,000 annually. She is married
to Sid Metcalf, a full-time student at State University. Sid earned $1,200 from
securities his grandmother had given him in 2008. Jane pays all of the
expenses incurred by the family, including their six-year-old adopted daughter,
Tari. The three individuals and two cats, Snowball and Frank, live in a
downtown condo. How many dependency exemptions may be claimed for tax
purposes? Explain.

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Lecture Outline

I. Personal and Dependency Exemptions

A. Each taxpayer is allowed one personal exemption]
1. Amount is $3,950 for 2014
2. A spouse on a joint return is never considered a dependent
B. Dependency requirements. There are now two types of dependent, each with
specific tests that must be met. (Example 1; Problems 30 and 31)
1. Qualifying Child: Five tests! Must pass all!
a. Age test: Child must be < 19 at end of year, or a full time
student <24, or permanently and totally disabled. (Example 2)
b. Non-support test: Child does not supply > 50% of their own
support (scholarships don’t count). (Example 3) [Note:
Taxpayer doesn’t have to supply >50% of support!]
c. Relationship test: Must be taxpayer’s child, stepchild, foster
child, or descendant of child. Can also be sibling, step-sibling,
or their descendant?
d. Principal Residence test: Child must live with taxpayer >50% of
year. (Absence due to illness, vacation, education, or military
service won’t count against test) (Examples 4 and 5)
e. Citizen of Residency test: Child must be U.S. citizen or resident
of U.S. or adjacent country.
2. Qualifying Relative: Five tests! Must pass all!
a. Gross income test: GI < exemption amount of $3,950 (Example
6)
b. Support test: Taxpayer provides > 50% support of dependent
(Examples 7 and 8)
1. Two exceptions for taxpayers who fail this test
a. Multiple Support Agreement (Example 9)
i. 2 or more people > 50% support $, and
ii. All 4 other dependency tests are met, and
iii. All members of support group sign form
designating who gets the exemption, then
Any 1 person who provides > 10% support
may claim
b. Children of divorced parents (Example 10)

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Ch 8: Taxation of Individuals

i. Custodial parent entitled regardless of $

amount of support
ii. Exception when custodial parent waives
rights in writing
c. Relationship test: Blood and lineal relationships (no cousins)
1. Exception for anyone living in household for entire year
d. U.S. Citizenship / Residency test: Residents of U.S., Canada, or
Mexico qualify
e. Joint Return test: Married dependents can't file joint return for
the year in question
1. Exception for a couple who would not have to file
because of minimum income level (filing requirements in
Table 8-5), but do (jointly) only for a refund of withheld
federal income tax

II. Filing Status (Problems 32 and 33)

A. Married, Filing Jointly
1. Legally married as of last day of tax year
a. Exception for death of a spouse: may file jointly for year of
death
2. Exception for Surviving Spouses with dependent children -- for the 2
subsequent years after death (Example 11)
a. Not married as of last day of year
b. U.S. resident
c. At least 1 dependent child lives at home through the end of tax
year
B. Married, Filing Separately -- must be legally married at year-end
1. Highest average tax rate of any filing status
2. Generally used when couples in financial disagreement and not
divorced or legally separated at year-end
C. Single -- means legally unmarried at year-end
1. Example 12 describes the marriage penalty tax that exists for couples
with approximately equal incomes
D. Head of Household must be unmarried at year-end
1. Provide > 50% cost of home maintenance, for a qualifying child or
qualifying relative.

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Ch 8: Taxation of Individuals

a. Dependent parents do not have to live with unmarried taxpayers

(retirement home exception)
b. Examples 13 and 14
2. Abandoned spouse exception for a married U.S. taxpayer permitting
HoH filing status, if
a. Dependent child lives in home for more than 1/2 year
b. Spouse does not live in home any time during last 1/2 year
(Example 15)

III. Deductions from AGI

A. Standard Deduction
1. Amount based on filing status and adjusted annually for inflation
(Amounts in Table 8-1) (Problems 34 to 37)
2. Additional standard deduction -- Blind or > 65 years old (Examples 16
and 17)
a. $1,550 extra standard deduction for single taxpayers
b. $1,200 extra for married taxpayers
c. These amounts don't affect itemized deductions (Examples 18
and 19)
B. Itemized Deductions represent legislative grace toward certain personal
expenses (Examples 20 and 21; Table 8-2)
1. Medical expenses for taxpayer, spouse, and dependent (Problems
38 and 39)
a. Dependent need only meet support, relationship, and residency
tests
b. Exhibit 8-2 has a summary of medical examples (most costs
qualify)
1. 23.5 cents a mile for travel
c. 10% (7.5% for taxpayers 65 and over) floor for deductible
amount as an administrative convenience -- few taxpayers
actually deduct any (Example 22)
2. Taxes
a. Greater of state and local income taxes paid or state and local
sales taxes paid (Problems 40 to 43; Examples 23 to 27)
1. State and local income taxes paid
a. Withheld + quarterly estimates + balance due for
the prior year; deduction is for taxes "paid." Most

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Ch 8: Taxation of Individuals

individuals are cash basis taxpayers. Remember

the annual accounting period concept.
b. Refunds received are included in Gross Income
only if tax benefit rule applies, where deductions
are itemized, i.e. didn't use Standard deduction
2. State and local sales taxes - 2 options
a. Available for tax years ending before 1/1/14
b. Deduct the actual amount paid in sales taxes
during the year based on receipts
c. Deduct amount from IRS table based on income
(Exhibit 8-3)
d. If table amount is chosen, sales tax paid on cars,
boats and other items specified may be added to
the table amount
b. Real estate taxes (Problem 44)
c. Personal property taxes -- ad valorem only (Example 27)
1. Vehicle license generally has both tax and registration
fee components
d. NOT deductible,
1. Federal taxes
2. Water use and sewer taxes
3. Excise taxes on alcohol, tobacco, and firearms
4. Assessments for streets or sidewalks
5. Sales taxes
6. Gasoline taxes
3. Interest
a. Home mortgage interest (Problems 45 to 48; Examples 28
and 29)
1. Debt secured by principal residence and/or one other
2. Qualified home mortgage interest includes
a. Interest on acquisition debt
i. cap of interest paid up to $1 million of debt
ii. excess considered personal interest
b. Home equity debt -- any debt secured by home
not part of acquisition
i. only interest paid on up to $100,000 of debt
ii. proceeds can be used for anything

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Ch 8: Taxation of Individuals

c. Premium paid or accrued for qualified home

mortgage insurance (Example 30)
i. for acquisition indebtedness on taxpayer’s
residence
ii. premiums paid or accrued before 1/1/14
iii. phased out if AGI exceeds $100,000
iv. phase out amount = 10% for each $1,000
($500 for married filing separately) or
portion thereof that AGI exceeds $100,000
d. total debt cannot exceed FMV of property
3. Points are prepaid interest paid to get financing
a. Stated as a % of loan value and paid at acquisition
b. Generally, capitalize and amortize over loan life
(Problem 46)
c. Exception -- Currently deductible for acquisition
mortgage on principal residence
d. Loan origination fees are for services rendered --
not points
4. Prepayment penalties are also currently deductible as
mortgage interest
b. Investment interest (Problems 50 to 52; Examples 31 and 32)
1. Interest paid on debt to buy portfolio investments (e.g.,
margin account interest)
2. Deduction limited to amount of net investment income for
the year
a. Excess carried forward and deducted when limit
permits
3. Net investment income is income from securities and
other investment assets less investment expenses
a. Gross income, gains (losses)
b. Net LT Capital gains and dividends taxed at 15%
not included
c. Expenses are ordinary and necessary directly
connected to production of investment income.
Note: these expenses are reduced by the
miscellaneous itemized deduction limit
4. Charitable Contributions

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Ch 8: Taxation of Individuals

a. Exhibit 8-4 summarizes rules: lists qualifying charities,

contribution measurement, and deduction maximum
b. Mileage at 14 cents per mile
c. Ordinary income property or short-term capital gain property
(Example 33)
1. Limited to lesser of
a. FMV, or
b. Adjusted basis of property
2. Use example of used clothing donated to Goodwill
Industries, valued at Goodwill's sales price (FMV)
d. Deduct FMV of contributions of long-term capital gain property --
unrealized gains never taxed (Examples 34 and 35; Problem
53)
e. Three major limitations on deductible amount (Example 34)
1. Overall = 50% of AGI
2. Capital gain property valued @ FMV = 30% of AGI
3. Capital gain property valued @ adj. basis use 50% limit
f. Contributions > limitation amount, carried forward 5 years
5. Casualty losses: Discussed in Chapter 7 (Problems 59 and 60)
6. Miscellaneous Itemized Deductions (Exhibit 8-5 has list of fully vs.
partially deductible items) (Problems 56 to 58)
a. 2% of AGI annual limitation on aggregate amount (Examples
36 and 37)
b. Meals and entertainment always subject to 50% per transaction
before any other limit
c. Investment expenses relating to the deduction of investment
interest are reduced by the 2% x AGI floor before calculating net
investment income. However, any other miscellaneous itemized
deductions are applied against the 2% x AGI amount before
investment expenses (Examples 38 and 39)
Note: students tend to have difficulty with the procedures used in Example 39.
C. Reduction of Itemized Deductions and Exemptions for High-income
Taxpayers (Table 8-3)
1. Phase out of itemized deductions (Example 40; Problem 61)
a. Threshold amount based on filing status
b. Reduced by 3% of AGI in excess of threshold amount

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Ch 8: Taxation of Individuals

c. Medical expenses, casualty and theft losses, investment interest,

and gambling losses exempt from phase-out
d. Cannot be reduced more than 80%
e. Indexed for inflation
2. Phase out of Exemptions (Example 41; Problem 62)
a. Threshold amount based on filing status
b.. Reduced by 2% of allowable exemption amount for each $2,500, or
portion thereof, that AGI exceeds the threshold amount
c. Can lose entire exemption amount

IV. Exemption and Standard Deduction Restrictions on Dependents

A. No exemption amount if claimed by another -- 1 exemption per human
1. Not negotiable --Person who meets the 5 tests gets the exemption
(Example 42)
B. Standard deduction for dependents (Examples 43 and 44; Problems 63 and
64)
1. $1,000, or
2. Earned income plus $350 up to amount of regular standard deduction
($6,200 for single taxpayers)

V. Calculating tax liability (Problem 65)

A. Tax liability (per rate or schedule) + additional taxes - credits - prepayments =
Tax (or refund) due
B. Kiddie tax (on Unearned Income of a Minor Child) (Example 45)
1. Tax the net unearned income (NUI) of a child under the age of 18 or a
full time student under the age of 24 at the parents’ marginal tax rate
2. NUI =
a. Unearned income,
b. Less $1,000,
c. Less the greater of $1,000 or the costs of producing the
unearned income
3. Unearned income over $2,000 is taxed at parents’ marginal tax rate --
effectively disallows assignment of unearned income to a minor child
4. Parents may elect to report this tax on their own return and not file a
return for the child.
C. Individual tax credits (Table 8-4)
1. Purposes

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Ch 8: Taxation of Individuals

a. Encourage taxpayers to engage in specific activities

b. Provide equitable treatment among taxpayers
c. Tax relief for low-income, elderly, and disabled taxpayers
2. Nonrefundable v Refundable
a. Refundable if taxpayer receives excess over tax liability
b. Nonrefundable can only reduce tax liability to zero
3. Child Credit (Problems 66 and 67) Caution: Students may confuse
this and the Child-Care Credit
a. $1,000 per qualifying dependent child (Example 46)
1. Must meet five tests to be Qualifying Child dependent,
except
2. Must be < 17 years old
3. Must be a U.S. citizen or resident
b. Phased-out at rate of $50 for each $1,000 of AGI > $110,000 for
MFJ or $75,000 for others (Example 47)
c. Child Credit may be refundable (Examples 48 and 49;
Problem 68)
1. With one or two qualifying children refundable amount is
15% X (Earned Income - $3,000)
2. With three or more qualifying children
a. maximum refund calculated as in (1), but
b. refund is limited to tax liability + Social Security tax
paid - Earned Income Credit
4. Earned Income Credit (EIC) is a refundable credit (Problems 69 and
70)
a. To qualify for EIC
1. Must live more than 1/2 of year in U.S.
2. Taxpayer (or spouse) must be > 24 and < 65 years old
3. Taxpayer (or spouse) can't be a dependent of another
4. Can’t have portfolio or passive income > $3,400
5. If married, must file joint return
b. EIC Calculation -- (Exhibit 8-6 for 2012 credit calculation)
(Examples 50 and 51)
5. Child and Dependent-Care Credit (Problems 71 and 72)
a. Credit for care of qualified individual to allow taxpayer to work
(Examples 52 to 54)
1. Paid for either household services or care

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2. For dependent < 13 years or physically or mentally

disabled spouse or dependent
b. Amount of credit = 35% x qualified expenditures
1. Qualified expenditures limit =
a. $3,000 for 1, or $6,000 for > 1 qualifying individual,
but
b. May not exceed earned income of taxpayer
(lowest earned income if MFJ) (Example 56)
2. 35% rate is reduced 1% for each $2,000 of AGI in excess
of $15,000. Minimum credit is 20% (when AGI > $43,000)
(Example 55)
6. Higher Education Credit (Problems 73 and 74)
a. Common requirements
1. Can be claimed in addition to the Coverdell Education
Savings Account distributions
2. Cannot claim if deduction is taken for higher education
expenses
3. May only claim one per qualifying student
a. Enrolled at least half-time
b. Enrolled at least one semester a year
b. The American Opportunity Tax Credit (AOTC) (formerly known
as the Hope Scholarship Credit) (Example 57)
1. 100% of first $2,000 of expenses
2. Plus 25% of next $2,000
3. Qualifying expenses
a. For higher education expenses of taxpayer,
spouse, or dependent
b. Tuition, related fees, and required course
materials
c. Reduced by amount of scholarship or fellowship
received
4. Available only first four years of undergraduate education
5. Phase out beginning at AGI > $160,000 for MFJ and
$80,000 for all other taxpayers (Example 59)
c. Lifetime Learning Credit (Example 58)
1. Maximum $2,000 per return
2. 20% of first $10,000 of qualifying expenses

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3. For any course work taken to acquire or improve skills

4. Qualifying expenses like AOTC except that the expenses
for required course materials are not included
5. Phase out beginning at AGI > $109,000 MFJ and
$54,000 for all other taxpayers (Examples 60)

VI. Filing Requirements (Table 8-5)

A. General requirements for individuals (Problems 75 and 76)
1. Must file when GI > (standard deduction + allowable personal
exemptions)
a. Note: Standard deduction does include extra amount for age
but not for blindness
b. No dependency exemptions are included in the calculation
2. Three Exceptions (Example 61)
a. Net self-employment income > $400 must file, regardless of GI
b. Married taxpayers filing separate returns must file if GI >
exemption amount ($3,950)
c. Dependent with unearned income who has GI > $1,000 must file

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Annotated Bibliography

Publication 970 (2010), Tax Benefits for Education, http://www.irs.gov/pub/irs-pdf/p970.pdf

PUBLICATION 501 (2010), EXEMPTIONS, STANDARD DEDUCTION, AND FILING ...

http://www.irs.gov/pub/irs-pdf/p501.pdf

TAX TOPICS - TOPIC 504 HOME MORTGAGE POINTS; MARCH 25, 2009
http://www.irs.gov/taxtopics/tc504.html

ESTABLISHING BASIS FOR GAMBLING LOSSES by Donald Morris, The Tax Adviser (June 2007)
www.aicpa.org/pubs/taxadv/online/jun2007/morris.htm
A discussion of how to calculate and prove taxable income, net winnings and basis or losses
claimed.

WHO GETS THE EXEMPTION? by Charles J. Reichert, Journal of Accountancy Online (January
2004), www.aicpa.org/pubs/jofa/jan2004/taxcases.htm#who
A discussion of the case, Jeffrey R. King and Sabrina M. King v. Commissioner; Jimmy R.
Lopez and Suzy O. Lopez v. Commissioner, 121 TC no. 12.

DEFERRED GIVING OF ART: THE JOY OF KEEPING YOUR TREASURE JUST A LITTLE BIT LONGER
by Hal McKinney, Jr., 28 Tax Adviser 474-77 (Aug. 1997)
Explores the possibility of donating works of art to museums through a standard charitable
trust arrangement that allows a percentage interest in the property as a current gift. Considers
the valuation of such interests and the prospect of minority interest discounts.

SIMPLIFICATION OF PHASE-OUTS: UNNECESSARY COMPLEXITY by AICPA Tax Division,

Individual Taxation Committee, 28 Tax Adviser 725 - 28 (Nov. 1997)
Text of a proposal prepared by the AICPA Working Group to eliminate the many complicated
phase-outs in the tax law and to adjust the tax rates accordingly.

TAX ASPECTS TO CONSIDER UPON JOB TERMINATION by Richard T. Lai and Alfred Panasci, 75
Taxes - The Tax Magazine 621 - 27 ( Nov. 1997)
A guide to the taxation of job termination benefits in the wake of the Taxpayer Relief Act of
1997.

BEYOND TAX RELIEF: LONG-TERM CHALLENGES IN FINANCING HIGHER EDUCATION by Thomas

J. Kane, 50 National Tax Journal 335-49 (June 1997)
Objects to educational tax incentives in the form adopted in the 1997 act as not well targeted
and ineffective in reducing the cost to families of future tuition increases. Recommends
greater reliance on income-contingent loan forgiveness as a way to pay for college.

INTEREST DEDUCTION FOR INDIVIDUALS: REVIEW AND UPDATE by Edward Schnee, 12 Akron Tax
Journal 181-204 (1996)

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Discusses the interest expense deduction for individuals in transactions that involve business
interest; interest on tax deficiencies; pass-through entities; investment interest; mortgage
interest for principal and second residences; and points.

CURTAILING THE ECONOMIC DISTORTIONS OF THE MORTGAGE INTEREST DEDUCTION by

William T. Mathias, 30 University of Michigan Journal of Law Reform 43-78 (Fall 1996).
Advocates repeal of the mortgage interest deduction. Evaluates major policy arguments for the
deduction, and concludes that the deduction is inefficient, inequitable, too costly, and not
justifiable on purely economic grounds.

THE KIDDIE TAX: A NUISANCE SOLUTION TO A NONEXISTENT PROBLEM by Richard C.E. Beck,
30 Family Law Quarterly 103-22 (Spring 1996).
Criticizes the kiddie tax as unfairly broad in application, overly complex, and inefficient.
Questions whether there was any abuse to be corrected (outright gifts are not an assignment of
income), and concludes that enforcement of prior law would have been a better approach.

WHAT CAN BE DONE ABOUT MARRIAGE PENALTIES? by Jonathan Barry Forman, 30 Family Law
Quarterly 1-22 (Spring 1996).
The income tax and social security systems create inequities (based on principles of couples
and marriage neutrality) for taxpayers who marry. Proposed solutions include individual filing,
credit for two- earner couples, children-based credits, and earnings sharing in FICA benefits
computation.

TAX POLICY AND THE OBLIGATION TO SUPPORT CHILDREN by Allan J. Samansky, 57:2 Ohio State
Law Journal 329-80 (1996).
Explores how the obligation to support children affects tax liability of the parents. Reviews the
workings of the personal exemption, head of household status, and EITC, and recommends
that low- and middle-income parents be allowed a deduction equal to the subsistence cost of
raising a child.

A CHANGING ENVIRONMENT IN THE SUBSTANTIATION AND VALUATION OF CHARITABLE

CONTRIBUTIONS by Pat Eason, Raymond Zimmermann, and Tim Krumwiede, 74 Taxes -- The Tax
Magazine 251-59 (Apr. 1996).
Reviews valuation and substantiation disclosure rules that apply to donors and recipients of
noncash charitable contributions, and considers the process for determining the fair market
value of such contributed property.

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