Chapter 3

Tax Determination; Personal and

Dependency Exemptions; An Overview
of Property Transactions

Individual Income Taxes

Copyright ©2009 Cengage Learning
Individual Income Taxes C3-1
 Tax Formula (slide 1 of 2)
Income (broadly conceived) $x,xxx
Less:Exclusions (x,xxx)
Gross Income $x,xxx
Less:Deductions for AGI (x,xxx)
Adjusted Gross Income (AGI) $x,xxx
Less:The greater of-
Total itemized deductions
or the standard deduction (x,xxx)
Personal & dependency exemptions (x,xxx)
Taxable Income $x,xxx
FIGURE 3–1

Individual Income Taxes C3-2

 Tax Formula (slide 2 of 2)
Tax on taxable income (see Tax Tables or
Tax Rate Schedules) $ x,xxx
Less: Tax credits (including income
taxes withheld and prepaid) (xxx)
Tax due (or refund) $ xxx

FIGURE 3–1

Individual Income Taxes C3-3

 Income -Broadly Conceived
• Includes all the taxpayer’s income, both
taxable and nontaxable
– Essentially equivalent to gross receipts
• It does not include a return of capital or receipt of
borrowed funds

Individual Income Taxes C3-4

 Partial List of Exclusions
from Gross Income
• Accident insurance proceeds • Meals and lodging (if furnished for
• Annuities (cost element) employer’s convenience)
• Bequests • Military allowances
• Child support payments • Minister’s dwelling rental value
• allowance
Cost-of-living allowance (for military)
• Railroad retirement benefits (to a
• Damages for personal injury or sickness limited extent)
• Gifts received • Scholarship grants (to a limited extent)
• Group term life insurance, premium • Social Security benefits (to a limited
paid by employer (for coverage up to extent)
$50,000)
• • Veterans’ benefits
Inheritances
• • Welfare payments
Interest from state and local (i.e.,
municipal) bonds • Workers’ compensation benefits
• Life insurance paid on death

Exhibit 3-1

Individual Income Taxes C3-5

 Gross Income
• The Internal Revenue Code defines gross
income broadly as ‘‘except as otherwise
provided . . . , all income from whatever
source derived’’
• Gross income does not include unrealized
gains

Individual Income Taxes C3-6

 Partial List of Gross Income Items
(slide 1 of 2)

• Alimony • Hobby income

• Annuities (income element) • Interest
• Awards • Jury duty fees
• Back pay • Living quarters, meals (unless
• Bargain purchase from employer furnished for employer’s
• convenience)
Bonuses
• • Mileage allowance
Breach of contract damages
• • Military pay (unless combat pay)
Business income
• Notary fees
• Clergy fees
• Partnership income
• Commissions
• Pensions
• Compensation for services
• • Prizes
Death benefits
• • Professional fees
Debts forgiven
• • Punitive damages
Director’s fees

Exhibit 3-2
Individual Income Taxes C3-7
 Partial List of Gross Income Items
(slide 2 of 2)

• Dividends • Rents
• Embezzled funds • Rewards
• Employee awards (in certain cases) • Royalties
• Employee benefits (except certain • Salaries
fringe benefits) • Severance pay
• Estate and trust income • Strike and lockout benefits
• Farm income • Supplemental unemployment
• Fees benefits
• Gains from illegal activities • Tips and gratuities
• Gains from sale of property • Travel allowance (in certain cases)
• Gambling winnings • Wages
• Group term life insurance,
premium paid by employer (for
coverage over $50,000)

Exhibit 3-2
Individual Income Taxes C3-8
 Deductions - Individual Taxpayers

• Individual taxpayers have two categories of

deductions:
– Deductions for adjusted gross income (AGI)
– Deductions from adjusted gross income

Individual Income Taxes C3-9

 Deductions For AGI (slide 1 of 2)
• Sometimes known as above-the-line
deductions
– On the tax return, they are taken before the
‘‘line’’ designating AGI

Individual Income Taxes C3-10

 Deductions For AGI (slide 2 of 2)
• Deductions for AGI include:
– Ordinary and necessary expenses incurred in a trade or
business
– One-half of self-employment tax paid
– Alimony paid
– Certain payments to an IRA and Health Savings
Accounts
– Moving expenses
– Fees for college tuition and related expenses
– Interest on student loans
– The capital loss deduction, and
– Others
Individual Income Taxes C3-11
 Adjusted Gross Income (AGI)
• AGI is an important subtotal
– Serves as the basis for computing percentage
limitations on certain itemized deductions such as
• Medical expenses
• Charitable contributions
• Certain casualty losses
– e.g., Medical expenses are deductible only to the extent
they exceed 7.5% of AGI
• This limitation might be described as a 7.5% “floor” under the
medical expense deduction

Individual Income Taxes C3-12

 Deductions From AGI (slide 1 of 3)
• Deductions from AGI include:
– The greater of:
• Itemized deductions, or
• The standard deduction
– Personal and dependency exemptions

Individual Income Taxes C3-13

 Deductions From AGI (slide 2 of 3)
• A partial list of itemized deductions includes:
– Medical expenses (in excess of 7.5% of AGI)
– Certain taxes and interest
– Charitable contributions
– Casualty Losses (in excess of 10% of AGI)
– Deductions for expenses related to
• The production or collection of income, and
• The management of property held for the production of income
– Certain miscellaneous itemized deductions (in excess of
2% of AGI)

Individual Income Taxes C3-14

 Deductions From AGI (slide 3 of 3)
• The standard deduction is the sum of two
components:
– Basic standard deduction
• Amount allowed is based on taxpayer’s filing status
– Additional standard deductions
• Available for taxpayers who are
– Age 65 or over, and
– Blind
• Two additional standard deductions are allowed for a taxpayer
who is age 65 or over and blind
• Amount allowed depends on filing status

Individual Income Taxes C3-15

 Standard Deduction
(slide 1 of 2)

• The basic standard deduction (BSD)

amount depends on filing status of taxpayer
Filing status 2007 2008 .
Single $5,350 $5,450
MFJ, SS 10,700 10,900
HH 7,850 8,000
MFS 5,350 5,450

TABLE 3–1

Individual Income Taxes C3-16

 Standard Deduction
(slide 2 of 2)

• Additional standard deduction (ASD)

– For taxpayers age 65 or older and/or legally
blind
Filing Status 2007 2008 .
Single $1,300 $1,350
MFJ, SS 1,050 1,050
HH 1,300 1,350
MFS 1,050 1,050
TABLE 3–2
Individual Income Taxes C3-17
 Determining Standard Deduction
• Examples (2008 tax year):
– Taxpayer is single, blind, and age 65 or older
• SD = $5,450 (BSD) + $1,350 (ASD) + $1,350
(ASD) = $8,150
– Taxpayers are married, filing jointly, one blind,
and both age 65 or older
• SD = $10,900 (BSD) + $1,050 (ASD) + $1,050
(ASD) + $1,050 (ASD) = $14,050

Individual Income Taxes C3-18

 Personal and Dependency
Exemption Amounts
• Amounts
– 2007: $3,400 per exemption
– 2008: $3,500 per exemption
• Personal and dependency exemptions
– One per taxpayer (two personal exemptions
when married, filing jointly) and for each
dependent
• Exception: Individual claimed as dependent by
another taxpayer does not receive a personal
exemption
Individual Income Taxes C3-19
 Taxpayers Ineligible For
Standard Deduction
• Certain taxpayers cannot use the SD:
– Married, filing separately, when either spouse
itemizes deductions
– Nonresident aliens
– Individual filing return for tax year of less than
12 months because of change in annual
accounting period

Individual Income Taxes C3-20

 SD Limit For Person
Claimed as Dependent
• Individual claimed as dependent has a BSD
limited to the greater of:
– $900 or
– $300 plus earned income (but not exceeding
normal BSD)
• ASD amount(s) still available

Individual Income Taxes C3-21

 Examples of SD Limit (slide 1 of 2)
• Dependent’s SD (2008 tax year):
– A blind child who earns $200 and is claimed by
parents as a dependency exemption
• SD = $900 (BSD) + $1,350 (ASD) = $2,250
– A child who earns $1,500 and is claimed by
parents as a dependency exemption
• SD = $1,800 [BSD equal to greater of $900 or ($300
+ $1,500 earned income)]

Individual Income Taxes C3-22

 Examples of SD Limit (slide 2 of 2)
• Examples of dependent’s SD (2008 tax
year)
– A child who earns $5,500 and is claimed by
parents as a dependency exemption
• SD = $5,450 [BSD limited to normal amount]

Individual Income Taxes C3-23

 Personal and Dependency
Exemptions In Year Of Death

• Personal exemption allowed on joint return

for spouse who dies during the year
– Example: Tom and Betty were married in 1990.
Tom dies on February 1, 2008. A personal
exemption may be claimed for Tom on the
taxpayers’ 2008 joint return.

Individual Income Taxes C3-24

 Dependency Exemptions (slide 1 of 2)

• A dependency exemption is available for

one who is either a qualifying child or a
qualifying relative
– A qualifying child must meet the following
tests:
• Relationship
• Abode
• Age, and
• Support
Individual Income Taxes C3-25
 Dependency Exemptions (slide 2 of 2)
• One objective of the Working Families Tax
Relief Act of 2004 (WFTRA of 2004)
– Establish a uniform definition of qualifying
child for purposes of the:
• Dependency exemption
• Head-of-household filing status
• Earned income tax credit
• Child tax credit
• Credit for child and dependent care expenses

Individual Income Taxes C3-26

 Relationship Test
• The child must be the taxpayer’s:
– Son or daughter
– Stepson or stepdaughter
– Brother or sister
– Stepbrother or stepsister
– Half brother or half sister, or
– A descendant of such individual (e.g., grandchildren,
nephews, nieces)
• A child who has been adopted, or whose adoption
is pending, qualifies
• A foster child may also qualify

Individual Income Taxes C3-27

 Abode Test
• A qualifying child must live with the
taxpayer for more than half of the year
– Temporary absences from the household due to
special circumstances (e.g., illness, education)
are not considered

Individual Income Taxes C3-28

 Age Test
• The child must be under age 19 or under
age 24 in the case of a student
– A student is a child who, during any part of five
months of the year, is enrolled full time at a
school or government-sponsored on-farm
training course
– Individuals who are disabled are not subject to
the age test

Individual Income Taxes C3-29

 Support
• To be a qualifying child, the individual must
not be self-supporting
– Cannot provide more than one-half of his or her
own support
– In the case of a full-time student, scholarships
are not considered to be support

Individual Income Taxes C3-30

 Tiebreaker Rules
• In situations where a child may be a
qualifying child for more than one person
– Tiebreaker rules specify which person has
priority in claiming the dependency exemption

Individual Income Taxes C3-31

 Qualifying Relative
• In order to claim a dependency exemption
for a qualifying relative, the following tests
must be met:
– Relationship
– Gross income
– Support

Individual Income Taxes C3-32

 Relationship Test
• The relationship test for a qualifying relative is
more expansive than for a qualifying child. Also
included are the following relatives:
– Lineal ascendants (e.g., parents, grandparents)
– Collateral ascendants (e.g., uncles, aunts)
– Certain in-laws (e.g., son-, daughter-, father-, mother-,
brother-, and sister-in-law)
• The relationship test also includes unrelated
parties who live with the taxpayer

Individual Income Taxes C3-33

 Gross Income Test
• Dependent’s gross income must be less than
the exemption amount ($3,500 for 2008)

Individual Income Taxes C3-34

 Support Test
• Taxpayer must provide more than 50% of the
qualifying relative’s support
– Only amounts expended are considered in the support
test
– Scholarships are not considered in the support test
• Two exceptions to the support test:
– Multiple support agreements
– Children of divorced parents

Individual Income Taxes C3-35

 Multiple Support Agreements
• Allows one member of a group providing > 50%
of support to claim individual even though no one
person provides > 50% support
– Eligible parties must provide > 10% of support
– Each eligible party must meet all other dependency
requirements
• Example - Allows children of elderly parent to
claim exemption for parent when none
individually meets the 50% support test

Individual Income Taxes C3-36

 Children of Divorced Parents
• Special rules apply if the parents meet the following
conditions:
– They would have been entitled to the dependency exemption had
they been married and filed a joint return
– They have custody (either jointly or singly) of the child for more
than half of the year
• Under the general rule, the parent having custody of the
child for the greater part of the year (i.e., the custodial
parent) is entitled to the dependency exemption
– General rule does not apply if
• A multiple support agreement is in effect
• Custodial parent issues a waiver in favor of the noncustodial parent

Individual Income Taxes C3-37

 Other Rules for
Dependency Exemptions
• In addition to fitting into either the
qualifying child or the qualifying relative
category, a dependent must also meet:
– The joint return, and
– The citizenship or residency tests

Individual Income Taxes C3-38

 Joint Return Test
• Dependent cannot file a joint return with
spouse unless:
– Filing solely for refund of tax withheld
– No tax liability exists for either spouse
– Neither spouse required to file return

Individual Income Taxes C3-39

 Citizenship or Residency Test
• Dependent must be a U.S. citizen or a
resident of U.S., Canada, or Mexico for
some part of the calendar year in which the
taxpayer’s tax year begins
– An exception provides that an adopted child
need not be a citizen or resident of the U.S. (or
a contiguous country) as long as his or her
principal abode is with a U.S. citizen

Individual Income Taxes C3-40

 Phase-out of Exemptions (slide 1 of 2)
Applies when taxpayer’s AGI in 2008 exceeds:
• $239,950 for married, filing jointly, or surviving spouse
• $199,950 for head of household
• $159,950 for single
• $119,975 for married, filing separately
• The phase-out of exemptions is being repealed in
two stages and will not be complete until 2010
– The exemption phaseout remains at two-thirds for 2006
and 2007 and at one-third for 2008 and 2009

Individual Income Taxes C3-41

 Phase-out of Exemptions (slide 2 of 2)
• Exemptions deduction is reduced by 2% for
every $2,500 ($1,250 for MFS), or part
thereof, that AGI exceeds threshold
amounts
– The amount of the phased-out exemptions is
then multiplied by 1/3 (the reduction-of-
phaseout fraction) for tax years 2008 and 2009

Individual Income Taxes C3-42

 Child Tax Credit
• $1,000 tax credit is allowed for each dependent
child under the age of 17
– Qualifying child includes stepchildren and eligible
foster children

Individual Income Taxes C3-43

 Taxes Rates
• Tax liability is computed using either the Tax
Table method or the Tax Rate Schedule method
– Most taxpayers must use the Tax Tables
– Certain taxpayers may not use the Tax Table method
including:
• An individual who files a short period return
• Individuals whose taxable income exceeds the maximum
(ceiling) amount in the Tax Table
– The 2007 Tax Table applies to taxable income below $100,000
• An estate or trust
• For 2008 the tax rates are 10%, 15%, 25%, 28%,
33%, and 35%

Individual Income Taxes C3-44

 Kiddie Tax (slide 1 of 4)
• Net unearned income (NUI) of child is
taxed at parents’ rate
– Child must be under age 19 at end of year
– NUI generally equals unearned income less
$1,800 (2008 tax year)

Individual Income Taxes C3-45

 Kiddie Tax (slide 2 of 4)
• Unearned income includes:
– Taxable interest
– Dividends
– Capital gains
– Rents
– Royalties
– Pension and annuity income, and
– Unearned income from trusts
Individual Income Taxes C3-46
 Kiddie Tax (slide 3 of 4)
• Computing NUI for Kiddie Tax:
Unearned income
Less: $900
Less: The greater of:
i) $900, or
ii) Allowable itemized deductions connected
with production of unearned income
Equals: net unearned income

Individual Income Taxes C3-47

 Kiddie Tax (slide 4 of 4)
• Net unearned income taxed at parents’ rate
– Remainder of taxable income taxed at child’s rate
• Two options for computing the tax
– A separate return may be filed for the child
• The tax on net unearned income (referred to as the allocable
parental tax) is computed as though the income had been
included on the parents’ return
– Form 8615 is used to compute the tax
– The parents may elect to report child’s income on their
own return
• Certain requirements must be met
Individual Income Taxes C3-48
 Filing Requirements (slide 1 of 2)
• General Rule: Tax return must be filed if
gross income is ≥ the sum of the standard
deduction and exemption amount
• ASD for blind does not apply for this determination
– Special rules apply for dependents and self-
employed taxpayers

Individual Income Taxes C3-49

 Filing Requirements (slide 2 of 2)
• Tax return of an individual is due on or before the
15th day of the 4th month after taxpayer’s year
end
– Most individuals are calendar year taxpayers, thus, due
date is April 15
• May obtain a 6 month extension of time to file
– Excuses a taxpayer from penalty for failure to file, not
from penalty for failure to pay
• If more tax is owed, extension request (Form 4868) should be
accompanied by check for balance of tax due

Individual Income Taxes C3-50

 Filing Status
• There are 5 filing statuses
– Single
– Married, filing jointly
– Surviving spouse (qualifying widow or widower)
– Head of household
– Married, filing separately
• Filing status affects tax rate brackets, standard
deduction, and other amounts

Individual Income Taxes C3-51

 Single Filing Status
• Includes a taxpayer who is unmarried or
separated from spouse by a divorce decree
or separate maintenance agreement and
does not qualify for another filing status
– Marital status is determined as of the last day of
the tax year
• When a spouse dies during the year, marital status is
determined as of the date of death

Individual Income Taxes C3-52

 Married Filing Jointly
(MFJ) Filing Status
• Married as of last day of taxable year, or
• Spouse dies during taxable year

Individual Income Taxes C3-53

 Surviving Spouse Filing Status
• Same tax rate brackets as married, filing
jointly
• File as surviving spouse for 2 years after
death of spouse if taxpayer maintains a
home in which a dependent child lives

Individual Income Taxes C3-54

 Married Filing Separately Filing Status

• Married but not filing a return with spouse

and not abandoned spouse

Individual Income Taxes C3-55

 Head of Household (HH) Filing Status

• Must be unmarried as of end of year or an

abandoned spouse
• Must pay > half the cost of maintaining a
household which is the principal home of a
dependent for more than half of tax year
– A dependent must satisfy either the qualifying child or
the qualifying relative category
• A qualifying relative must also meet the relationship test

Individual Income Taxes C3-56

 Exception to the HH
Requirements
• HH may be claimed if taxpayer maintains
a separate home for his or her parents
– At least one parent must qualify as a
dependent

Individual Income Taxes C3-57

 Abandoned Spouse
• Allows married taxpayer to file as Head of
Household if taxpayer:
– Does not file a joint return
– Paid > half the cost of maintaining a home
– Spouse did not live in home during last 6
months of tax year
– Home was principal residence of taxpayer’s
child for > half of year
– Can claim child as a dependent

Individual Income Taxes C3-58

 Gains and Losses from Property
Transactions (slide 1 of 3)
•In order for gains (losses) to be recognized
(included in gross income), they must be
realized:
–Realized gain (loss) = amount realized - adjusted basis
•Amount realized = selling price - costs of disposition
•Adjusted basis = cost + capital additions - cost recovery

Individual Income Taxes C3-59

 Gains and Losses from Property
Transactions (slide 2 of 3)
• All realized gains are recognized unless a
specific tax provision provides otherwise
(e.g., nontaxable exchanges)
• Realized losses may or may not be
recognized depending on the circumstances
– Generally, losses on the sale or disposition of
personal use property are not recognized

Individual Income Taxes C3-60

 Gains and Losses from Property
Transactions (slide 3 of 3)
• Once recognized gains or losses have been
determined, they must be classified as
ordinary or capital
– Ordinary gains are fully taxable
– Ordinary losses are fully deductible
• Capital gains and losses are subject to
special tax treatment

Individual Income Taxes C3-61

 Gains and Losses from Capital
Asset Transactions (slide 1 of 2)
• Capital assets are defined as any property other
than:
– Inventory,
– Accounts Receivable, and
– Depreciable property or real property used in a business
• Most personal use assets owned by individuals are
capital assets
– Losses on these assets are not deductible

Individual Income Taxes C3-62

 Gains and Losses from Capital
Asset Transactions (slide 2 of 2)
• Gains and losses from capital asset
transactions must be netted
– Net gains and losses by holding period
– If excess losses result, they are shifted to the
category carrying the highest tax rate

Individual Income Taxes C3-63

 Max Tax Rates for Net
Capital Gains of Individuals
Classification Maximum Rate
Short-term gains (held ≤ one year) 35%
Long-term gains (held > one year)
• Collectibles 28%
• Certain depreciable property
used in a trade or business
(unrecaptured § 1250 gain) 25%
• All other long-term capital gains 15%, 5%,
or 0%

Individual Income Taxes C3-64

 Treatment of Capital Losses
• Net capital losses of individuals are
deductible FOR AGI up to $3,000 yearly
– Excess capital losses are carried over to the
next tax year
– When carried over, capital losses retain their
classification as short- or long-term

Individual Income Taxes C3-65

 If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:

Dr. Donald R. Trippeer, CPA

trippedr@oneonta.edu
SUNY Oneonta

Individual Income Taxes C3-66