Chapter 8 Individual Income Tax Computation and Tax Credits - PowerPoint Presentation

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Chapter 8

Individual Income Tax Computation and Tax CreditsSlide2

Learning Objectives

Determine a taxpayer’s regular tax liability and identify tax issues associated with the process.

Compute a taxpayer’s alternative minimum tax liability and describe the tax characteristics of taxpayers most likely to owe the alternative minimum tax.

Calculate a taxpayer’s employment and self-employment 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 (cont’d)

Describe the different general types of tax credits, identify specific tax credits, and compute a taxpayer’s 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 taxpayer’s underpayment, late filing, and late payment penalties.

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Federal Income Tax Computation

Regular tax computation dependent upon:

Filing status

Married filing jointlyQualifying widow or widower (also called Surviving spouse)Married filing separatelyHead of household

Single

Progressive tax rates

Tax rate schedules

Tax tables

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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 benefitWho is likely to have penalty?Both spouses receive incomeWho is likely to have benefit?One spouse receives income

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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 possibleDividendsQualified 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 Courtney’s taxable income is $449,000 including $15,000 of qualifying dividends taxed at the preferential rate. What would be Courtney’s tax liability under these circumstances?

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Tax Computation Example Solution

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Net Investment IncomeTax

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 $2,100Parents 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 child’s support, or

Child is over age 18 but under age 24, is a full-time student, and child’s earned income not greater than half of child’s support.

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Kiddie Tax Example

Suppose that during 2015, Deron received $1,100 in interest from an IBM bond, and he received another $2,200 in interest income from a money market account that his parents have been contributing to over the years. What is Deron’s taxable income and corresponding tax liability? (Deron’s 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 $2,100, he is potentially subject to the kiddie tax.

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Kiddie Tax Example Solution (cont’d)

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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 taxesReal property taxesHome-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 so prevalent?

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)

$118,500 limit applies to Social Security portionMultiple employers during yearEmployerPays FICA tax on employee’s compensation (6.2% Social Security tax rate; 1.45% Medicare tax rate)& withholds FICA tax from employee’s pay check

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Employment and Self-Employment 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 $118,500 limit applies to Social Security portion

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Employment and Self-Employment Taxes

If net earnings from self-employment < $400, no SE tax.

How does $118,500 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 Self-Employment Taxes Example

Assume that Courtney received $100,000 of taxable compensation from EWD in 2015, 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?

Assume that Courtney’s employer correctly withheld $6,200 of Social Security tax, $1,450 of Medicare tax, and $0 of .9 percent additional Medicare tax.

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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?

Tax differencesAmount of FICA or SE taxes payableDeductibility of expensesFor AGI From

AGI

Employer portion of self-employment taxes

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Tax Credits

Reduce tax liability dollar for dollar

Consist of three categories

Nonrefundable personalRefundable personalBusiness

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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 situationsPhase-out amount not percentageChild and Dependent care creditDependent 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 8-9)

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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 onlyApplied per studentTaxpayer, spouse, taxpayer’s dependentsAmounts 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 Missouri–Kansas 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 schoolIncludes continuing educationApplied per taxpayerMFJ return is one taxpayer20% 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 personCould 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 incomeMust have at least one qualifying child or must be at least 25 years old and less than 65 and not a dependent of anotherSee Exhibit 8-10

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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 yearsForeign tax creditHybrid 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

WithholdingsTreated as made equally throughout the yearEstimated tax paymentsDue on April 15th,, June 15

th

, September 15

th

, and January 15

th

of the following year

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Prepayments and Filing Requirements

Underpayment

penalties

Safe-harbor requirements90% of current tax liability or100% of previous year’s 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 basis90%/4 = 22.5% of current year liability must be paid in by deadline or100%/4 = 25% of previous year’s liability must be paid in by deadlinePenalty 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 amountLower thresholds for those claimed as dependent on another’s tax return

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Prepayments and Filing Requirements

Due dates

April 15

th Extend filing up to six monthsMay 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 fraudulentNo penalty if no tax is dueLate payment penaltyIf don’t 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

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 $2,860 made payable to the United States Treasury. The $2,860 consisted of her underpaid tax liability of $2,830 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 $142 ($2,830 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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