Chapter 4
Individual Income Tax Overview,
Exemptions, and Filing Status
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Learning Objectives
1.
2.
3.
Describe the formula for calculating an
individual’s tax liability and generally
explain each formula component.
Explain the requirements for determining a
taxpayer’s personal and dependency
exemptions.
Determine a taxpayer’s filing status.
4-2
Individual Income Tax Formula




Gross income
Minus: For AGI deductions
Equals Adjusted gross income
Minus: From AGI deductions:

Greater of (a) Standard deduction or
(b) Itemized deductions
and


Personal and dependency exemption
Equals Taxable income
4-3
Individual Income Tax Formula
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
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
Taxable income
Times: Tax rates
Equals: Income tax liability
Add: Other taxes
Equals: Total tax
Minus: Credits
Minus: Prepayments
Equals: Taxes due or (refund)
4-4
Individual Income Tax Formula

Individuals report taxable income to the IRS


Reported on Form 1040
U.S. tax laws use all-inclusive gross income
concept

Realized income



measurable change in property rights
All realized income included in gross income unless
specifically excluded or deferred
Recognized income

Reported on tax return
4-5
Individual Income Tax Formula


Excluded and Deferred income not included
in gross income
Excluded income

Income never included in taxable income



Municipal bond interest
Gain on sale of personal residence
Deferred income

Income included in a subsequent tax year


Installment sales
Like-kind exchanges
4-6
Individual Income Tax Formula

Character of income or loss






Determines rates applicable to income or loss in current
year
Tax exempt – no tax
Tax deferred – no tax in current year (current year tax rate
is zero)
Ordinary – ordinary rates from tax rate schedule
Qualified dividends taxed at 0, 15%, or 20% depending on
taxpayer’s income level
Capital gain or loss – depends on whether short-term or
long-term
 From selling capital asset
 If held capital asset more than a year gain or loss is longterm, otherwise it is short-term

Net long-term gains taxed at preferential rates
4-7
Individual Income Tax Formula

Capital assets

Generally all assets except



Accounts receivable
Inventory
Assets used in trade or business, including supplies
4-8
Individual Income Tax Formula

Capital gains and losses



Net long-term capital gains in excess of net shortterm capital losses are generally taxed at 0%,
15%, or 20% depending on the taxpayer’s taxable
income
Short-term capital gains taxed at ordinary rates
Net capital losses (losses in excess of gains for
year)


$3,000 deductible against ordinary income for year
Losses in excess of $3,000 carried forward
4-9
Individual Income Tax Formula

Deductions for AGI



Deductions “above the line”
Deducted in determining adjusted gross income
Always reduce taxable income dollar for dollar
4-10
Individual Income Tax Formula

Deductions from AGI

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
Deductions “below the line”
Deducted from adjusted gross income to
determine taxable income
Greater of standard deduction or itemized
deductions
Personal and dependency exemptions
Why might a from AGI deduction not reduce
taxable income?
4-11
Individual Income Tax Formula

2014 Standard deduction amounts

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$12,400 Married filing jointly
$12,400 Qualifying widow or widower
$6,200 Married filing separately
$9,100 Head of household
$6,200 Single
Additional standard deduction amounts for age
and eyesight (discuss in Chapter 6)
4-12
Individual Income Tax Formula

Tax calculation


The U.S. uses a progressive tax rate schedule
Some items are taxed at preferential rates



Long-term capital gains
Qualified dividends
Tax on these items is calculated separately from
income taxed at ordinary rates.
4-13
Individual Income Tax Formula

Other taxes include:

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Alternative minimum tax
Self-employment taxes
3.8% Net investment income tax (also called the
Medicare Contribution tax on net-investment
income)
Tax credits

Reduce tax liability dollar for dollar
4-14
Individual Income Tax Formula
Tax prepayments

Payments already made towards tax liability including:




•
Income taxes withheld from wages by employer
Estimated tax payments made during the year
Taxes overpaid in prior year and applied toward current
year’s liability
If prepayments exceed tax liability after
credits, taxpayer receives a refund
4-15
Personal and Dependency Exemptions

Personal exemptions


Dependency exemptions


For taxpayer and spouse if married filing jointly
For those who qualify as the taxpayers’
dependents
Exemption amount for 2014 is $3,950
4-16
Personal and Dependency Exemptions

Dependency requirements


Citizen of U.S. or resident of U.S., Canada, or
Mexico
Must not file joint return with spouse


Exception – if no tax liability filing jointly or separately
Must be qualifying child or qualifying relative of
taxpayer
4-17
Personal and Dependency Exemptions

Qualifying child




Relationship test
Age test
Residence test
Support test
4-18
Qualifying Child

Relationship test

taxpayer’s son, daughter, stepchild, an eligible
foster child, brother, sister, half brother, half sister,
stepbrother, stepsister or a descendant of any of
these relatives.
4-19
Qualifying Child
Age test: child must be younger than the
individual claiming the child as a qualifying
child and either
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under age 19 at the end of the year,
under age 24 at the end of the year and a fulltime student, or
permanently and totally disabled.
4-20
Qualifying Child
 Residence test

Same residence as taxpayer for more than half
the year


Exception for temporary absences such as education.
Support test

Child must not provide more than half of his or her
own support

Scholarships of actual child (not grandchild, for
example) are excluded from support computation
4-21
Qualifying Child

Tie breaking rules



Parents first
Days living with each parent if parents living apart
AGI– higher AGI gets exemption
4-22
Personal and Dependency Exemptions

Qualifying relative

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Relationship test
Support test
Gross income test
4-23
Qualifying Relative

Relationship test
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a descendant or ancestor of the taxpayer (e.g.,
child, grandchild, parent, or grandparent),
a sibling of the taxpayer including a stepbrother or
stepsister
a son or daughter of the taxpayer’s brother or
sister (not cousins)
a sibling of the taxpayer’s mother or father
in-law (mother-in law, father-in-law, sister-in-law,
and brother-in-law) of the taxpayer, or
unrelated person who lives in taxpayer’s home
entire year
4-24
Qualifying Relative

Support test

Taxpayer must pay > ½ of living expenses
(support)


Scholarships of actual child excluded
Gross income test

Gross income < personal exemption amount
4-25
Personal and Dependency Exemptions
4-26
Filing Status

Five different filing statuses
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Married filing jointly
Married filing separately
Qualifying widow or widower (surviving spouse)
Single
Head of household
4-27
Filing Status

Married filing jointly

Must be married on the last day of the year

If one spouse dies the surviving spouse is considered
to be married to decedent spouse at year end


Exception – The surviving spouse remarries before year end
Joint and several liability for tax
4-28
Filing Status

Married filing separately

Taxpayers are married but file separate returns

Typically not beneficial from tax perspective


Tax rates and other tax benefits
May be beneficial for non-tax reasons

No joint and several liability
4-29
Filing Status

Qualifying widow or widower



Available for the two years following the year of
spouse’s death
Surviving spouse does not qualify if remarries
during two-year period.
Surviving spouse must maintain household for
dependent child
4-30
Filing Status

Single

Unmarried unless qualify for head of household
4-31
Filing Status

Head of household

Unmarried or considered unmarried at end of year




See discussion of married individuals treated as
unmarried (abandoned spouses) below
Not a qualifying widow or widower
Pay more than half the costs of keeping up a
home during the year
Lived in taxpayer’s home with a “qualifying
person” for more than half of the year

Exception for parents (see below)
4-32
Filing Status

Qualifying person
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
Qualifying child
Qualifying relative who is taxpayer’s mother or
father



Parent need not live with taxpayer
Taxpayer must pay > ½ cost of maintaining separate
household for taxpayer’s mother or father
Parent must qualify as taxpayer’s dependent
4-33
Filing Status

Qualifying relative who is not the taxpayer’s
parent



Person must have lived with taxpayer for more than
half the year
Must qualify as taxpayer’s dependent
Must be related to taxpayer through qualified family
relationship

If related only because lived with taxpayer for entire year,
not a qualified person.
4-34
Filing Status

Head of household

Married individuals treated as unmarried
(abandoned spouse) if individual



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Is married at end of year (or is not legally separated from
the other spouse)
Does not file a joint tax return with the other spouse
Pays > ½ the cost of maintaining a household that
serves as principal abode for qualifying child for more
than half the year
Lived apart from the other spouse for the last six months
of the year (other than temporary absences)
4-35
Filing Status Example
Assume that last year Rodney passed away,
and during the current year Anita did not
remarry but maintained a household for
Braxton and Tara, her dependent children.
Under these circumstances, what would Anita’s
filing status be?
4-36
Filing Status Example
Answer: Qualifying widow
4-37
Filing Status Example
Assume Rodney and Anita divorced last year.
During the current year, Braxton lives with Anita
and Anita pays all the costs of maintaining the
household for herself and Braxton. Under these
circumstances, what is Anita’s filing status for
the current year?
4-38
Filing Status Example
Answer: Head of household
4-39
Filing Status Example
Assume Shawn (Rodney’s brother) lived with the
Halls, but Shawn paid more than half the costs of
maintaining a separate apartment that is the principal
residence of his mother, Sharon, whose gross income
is $1,500. Because Shawn provided more than half of
Sharon’s support during the year, and because
Sharon’s gross income was only $1,500, she qualifies
as Shawn’s dependent (as a qualifying relative). In
these circumstances, what is Shawn’s filing status?
4-40
Filing Status Example
Answer: Head of household. Shawn paid
more than half the costs of maintaining a
separate household that is the principal place
of abode for his mother, and his mother
qualifies as his dependent.
4-41