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Chapter 7

Individual Income Tax Computation and Tax Credits

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Learning Objectives
1. 2.

3.

Determine a taxpayers regular tax liability and identify tax issues associated with the process. Compute a taxpayers alternative minimum tax liability and describe the tax characteristics of taxpayers most likely to owe the alternative minimum tax. Calculate a taxpayers employment and selfemployment taxes payable and explain tax considerations relating to whether a taxpayer is considered to be an employee or a self-employed independent contractor.

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Learning Objectives (contd)


4.

5.

Describe the different general types of tax credits, identify specific tax credits, and compute a taxpayers allowable child tax credit, child and dependent care credit, earned income credit, American opportunity credit, lifetime learning credit, and earned income credit. Explain taxpayer filing and tax payment requirements and describe in general terms how to compute a taxpayers underpayment, late filing, and late payment penalties.

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Federal Income Tax Computation

Regular tax computation dependent upon:

Filing status

Married filing jointly Qualifying widow or widower (also called Surviving spouse) Married filing separately Head of household Single
Tax rate schedules Tax tables
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Progressive tax rates


Federal Income Tax Computation

Tax brackets or marginal tax rates on ordinary income

10%, 15%, 25%, 28%, 33%, 35%, and 39.6%

Marriage penalty or benefit

Who is likely to have penalty?

Both spouses receive income One spouse receives income


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Who is likely to have benefit?

Federal Income Tax Computation

Exceptions to ordinary tax rates

Long-term capital gains (net capital gains)

Generally 0%,15%, or 20%, but can be as high as 28% Two different tax rates on one gain is possible

Dividends

Qualified dividends generally taxed at 0%,15%, or 20% Two different tax rates on one dividend is possible
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Tax Computation Example


Assume that Grams taxable income is $36,750 including $4,000 of qualifying dividends taxed at the preferential rate. What would be Grams tax liability on her income under these circumstances?

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Tax Computation Example Solution

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Medicare Contribution Tax

3.8% tax imposed on lesser of:

Net investment income (e.g., interest, dividends, annuities, royalties, rents, passive activity income, net gains from disposing of property, less related allowed deductions) or Excess of modified AGI over $250,000 (MFJ), $125,000 (MFS), and $200,000 (all others)

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Federal Income Tax Computation

Kiddie tax

Net unearned income taxed at parents marginal rate Net unearned income = unearned income in excess of $2,000 Parents can elect to actually include this income on their tax return. Applies if Child is under age 18 at year end, Child is 18 at year end but earned income not greater than half of childs support, or Child is over age 18 but under age 24, is a full-time student, and childs earned income not greater than half of childs support.
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Kiddie Tax Example


Suppose that during 2013, Deron received $1,100 in interest from an IBM bond, and he received another $2,100 in interest income from a money market account that his parents have been contributing to over the years. What is Derons taxable income and corresponding tax liability? (Derons mother Courtney is subject to a 25% marginal tax rate.)

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Kiddie Tax Example Solution


Because Deron is younger than 18 years of age at the end of the year and his net unearned income exceeds $2,000, he is potentially subject to the kiddie tax.

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Kiddie Tax Example Solution (contd)

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Alternative Minimum Tax Formula

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Alternative Minimum Tax

Items commonly added back to regular taxable income in computing AMT income

Personal and dependency exemptions State income taxes Real property taxes Home-equity loan interest expense (if proceeds not used to improve home) Miscellaneous itemized deductions in excess of 2% floor

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Alternative Minimum Tax

Exemption phased out 25 cents for each dollar over threshold

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Alternative Minimum Tax

AMT is a tax based on an alternative more inclusive tax base than regular taxable income.

Meant to ensure that taxpayers are paying some minimum level of tax.

Who is most likely to pay it and why?


High state taxes Multiple children Capital gains

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Alternative Minimum Tax

Why is it becoming so prevalent?

Exemption phase-out threshold not indexed for inflation Individual tax rates have decreased since AMT enacted

AMT rates 26% or 28% vs. individual ordinary rates 10%, 15%, 25%, 28%, 33%, 35%, 39.6%

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Employment FICA Taxes

Employee

Must pay FICA taxes on compensation from employer (6.2 % Social Security tax rate; 1.45% to 2.35% Medicare tax rate) $113,700 limit applies to Social Security portion Multiple employers during year Pays FICA tax on employees compensation (6.2% Social Security tax rate; 1.45% Medicare tax rate) & withholds FICA tax from employees pay check
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Employer

Employment and SelfEmployment Taxes

Self-employed taxpayers
Responsible for entire FICA tax (employee and employer share) Tax base is net earnings from self-employment (net Schedule C income (generally) and multiply by .9235) Same $113,700 limit applies to Social Security portion

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Employment and SelfEmployment Taxes

If net earnings from self-employment < $400, no SE tax. How does $113,700 Social Security earnings limit apply when have both wages and SE earnings in the same year?

Wages use up limit first taxpayer favorable or unfavorable? Why?

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Employment and SelfEmployment Taxes Example


Assume that Courtney received $100,000 of taxable compensation from EWD in 2013, and she received $180,000 in self-employment income from her weekend consulting activities. What amount of self-employment taxes is Courtney required to pay on her $180,000 of business income?

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Employment and Self-Employment Taxes Example Solution

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Employee vs. Independent Contractor

Determining whether taxpayer is employee or independent contractor

Primary question: who has control over how, when, where work is performed?
Amount of FICA or SE taxes payable Deductibility of expenses For AGI From AGI Employer portion of self-employment taxes

Tax differences

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Tax Credits

Reduce tax liability dollar for dollar Consist of three categories


Nonrefundable personal Refundable personal Business

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Nonrefundable Personal

Child tax credit

$1,000 for each qualifying child under age 17 at end of year Partially refundable in certain situations Phase-out amount not percentage Dependent under age of 13 (or disabled dependent) Percentage of qualifying expenditures Maximum qualifying expenditures: $3,000 one qualifying person, $6,000 two or more qualifying persons Percentage depends on AGI (see Exhibit 7-9)

Child and Dependent care credit


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Nonrefundable Personal

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Nonrefundable Personal

American opportunity credit (formerly Hope scholarship credit)

For first four years of post-secondary education For eligible expenses and institutions only Applied per student Taxpayer, spouse, taxpayers dependents Amounts paid by dependents treated as paid by taxpayer 100% of first $2,000 of eligible expenses and 25% of next $2,000 (maximum credit is $2,500) Phase-out based on AGI 40% of credit is refundable
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American Opportunity Credit Example


Courtney paid $2,000 of tuition and $300 for books for Ellen to attend the University of MissouriKansas City during the summer at the end of her freshman year. What is the maximum American opportunity credit (before phase-out) Courtney may claim for these expenses?

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American Opportunity Credit Example Solution


Answer: $2,075. Because the cost of tuition and books are eligible expenses, Courtney may claim a maximum American opportunity credit before phase-out of $2,075 [($2,000 100%) + ($2,300 - $2,000) 25%].

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American Opportunity Credit Example


Assuming Courtney qualifies for a $2,075 American opportunity credit, she is married filing jointly, and her AGI is $162,000, what amount of American opportunity credit would she be allowed to claim after phase-out?

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American Opportunity Credit Example Solution

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Nonrefundable Personal

Lifetime learning credit

Eligible expenses (tuition) for post-secondary education

Includes professional or graduate school Includes continuing education MFJ return is one taxpayer

Applied per taxpayer

20% of up to $10,000 of eligible expenses Phase-out based on AGI

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Nonrefundable Personal

Education credits

If deduct for AGI educational expenses for someone, no education credit allowed for that person

Could take American opportunity credit for one dependent and for AGI deduction for another

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Refundable Personal

Earned income credit


Negative income tax Must have earned income Must have at least one qualifying child or must be at least 25 years old and less than 65 and not a dependent of another See Exhibit 7-10

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Refundable Personal

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Tax Credits

Business credits

Promote certain behaviors If credit exceeds tax, carry back one year and carry forward 20 years Foreign tax credit

Hybrid business and personal nonrefundable; carry back one year and carry forward 10 years

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Tax Credits

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Prepayments and Filing Requirements

Taxes must be paid-as-you-go

Withholdings

Treated as made equally throughout the year

Estimated tax payments

Due on April 15th, June 15th, September 15th, and January 15th of the following year

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Prepayments and Filing Requirements

Underpayment penalties
Safe-harbor requirements

90% of current tax liability or 100% of previous years tax liability (110% with higher AGI > $150,000) 25% at each estimated filing deadline

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Prepayments and Filing Requirements

Underpayment penalties
Applied on quarterly basis

90%/4 = 22.5% of current year liability must be paid in by deadline or 100%/4 = 25% of previous years liability must be paid in by deadline

Penalty based on amount of underpayment at each quarter x federal short term rate + 3%

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Prepayments and Filing Requirements

Filing requirements
Generally, must file if gross income > standard deduction + personal exemption amounts If married filing separately must file if gross income > personal exemption amount Lower thresholds for those claimed as dependent on anothers tax return

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Prepayments and Filing Requirements

Due dates
April 15th Extend filing up to six months

May not extend due date for paying taxes

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Prepayments and Filing Requirements

Late filing penalty

5% of tax owed per month up to 25% if not fraudulent; 15% of tax owed per month up to 75% if fraudulent No penalty if no tax is due If dont pay entire tax owed by due date of return .5% of amount due up to 25% maximum if not fraudulent 15% of amount due per month up to 75% if fraudulent

Late payment penalty

Combined late filing and late payment penalties may not exceed maximum amounts for either one

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Late Filing and Late Payment Penalty Example


Assume Courtney filed her tax return on April 10 and included a check with the return for $2,896 made payable to the United States Treasury. The $2,896 consisted of her underpaid tax liability of $2,866 and her $30 underpayment penalty. If Courtney had waited until May 1 to file her return and pay her taxes, what late filing and late payment penalties would she owe?
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Late Filing and Late Payment Penalty Example Solution


Answer: Her combined late filing penalty and late payment penalty would be $143 ($2,866 late payment 5 percent 1 month or portion thereof). Note that the combined late filing and late payment penalty is limited to 5 percent per month.

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