Chapter 8: Individual Income Tax Computation & Tax Credits

What are the possible compications when computing taxpayer’s tax liablity?

• Not all income is taxed using the tax tables/schedules

• Additional Taxes

  • Taxpayers may be required to pay taxes in addition to their regular tax liability

• Tax Credits

  • Tax credits may reduce a taxpayer’s gross tax liability

• Penalties

  • If noncompliant, taxpayers may have to pay penalties

What varies across tax rate schedules (for ordinary income)

Range

What is a marriage penalty?

When married individuals have a greater tax liability because they are married (MFJ), as opposed to single individuals

• Does not compare MFJ vs MFS

  • Only compares MFJ vs Single (2)

What type of taxpayer is most likely to incur a marriage penalty?

Married high income earner (two high-income individuals who get married)

What is a marriage benefit?

When a married couple has a lower tax liability because they are married compared to if they were unmarried

What types of taxpayers are most likely to have marriage benefit?

Generally single “breadwinner” couples

What types of income are taxable, but not using the ordinary tax schedule?

• Capital gains and qualified dividends

What are the steps to calculate tax liability when a taxpayer has both ordinary and preferential income?

1. Split taxable income into ordinary and preferential parts

2. Compute tax separately on each type

3. Sum all the taxes and plug it into tax liability

What is the kiddie tax?

A rule to prevent parents from shifting unearned income to a young child bt transferring the asset to the child (whom the parent still controls)

When does the kiddie tax rule kick in?

• When unearned income-generating assets are transferred to a child that

  • <18 at year's end, and their unearned income is less than half of their support

  • OR

  • The child is over age 18 but under age 24 at year's end, is a full time student during the year, and their earned income<half of their support (excluding scholarships)

What happens if the kiddie tax rule applies?

The child’s net unearned income is taxed at their parent’s tax rate

• Tax basis for kiddie tax → child’s net unearned income

What is the net unearned income for children (in the context of kiddie taxes)

Lesser of the following:

• Child’s gross unearned income minus 2,700

• or

• The child’s taxable income

How much unearned income can parents shift to their children in a year?

2,700

What does AMT stand for?

Alternative minimum tax

What is the purpose of the AMT

Ensure that taxpayers generating income pay a minimum amount of tax each year.

It is meant to more closely represent economic income as opposed to the regular tax base

What is the Alternative minimum tax formula?

AMT= Tentative minimum tax - regular tax

How is modified AGI calculated for net investment income tax?

Modified AGI = AGI plus income excluded under the foreign earned income exclusion (FEIE) minus deductions associated with the FEIE

How is Net investment income tax calcuated?

3.8% × the lessor of the following:

• Net investment income and the excess over the thresholds (provided on the cheat sheet)

For the purpose of calculating Net Investment Income, how is net investment income calculated?

• Gross income from interest, dividends, annuities, royalties, and rent

• Income from a trade or business that is a passive activity or a trade or business of trading financial instruments or commodities

• Net gain from disposing of non-business property

Less the allowable deductions that are allocated to the first three items

What makes up employee FICA taxes?

Social Security: 6.2% of the first 176,100 of wages

• Employers pay the same

Medicare: 1.45% of wages

• Employees pay the additional medicare tax of 0.9% above a threshold (cheat sheet)

How does a taxpayer calculate their self-employment taxes?

1. Compute the amount of the taxpayer’s net income from self-employment activities that is subject to self-employment tax

2. Multiply income from step 1 by 92.35% (this yields net earnings from investment activities). This is basically removing the employer’s portion of the taxes to achieve parity with other taxpayers

3. Calculate social security tax by multiplying 12.4% (6.2% × 2) times the lesser of the net earnings given from step 2 or 176,100

4. Calculate Medicare tax component by multiplying the net earnings from step 2 by 2.9% (1.45% × 2)

• The additional medicare tax is NOT a self-employment tax because employers do not pay extra, only the employee does (none of it is deductible)

What is the additional medicare tax, who pays is, and how much is it?

An additional tax of 0.9% for income in excess of 200,000

What are the factors that determine if someone is self-employeed (independent contractor) or if they are an employee

• Set your own working hours

• Work for more than one firm

• Realized either a profit or a loss from the activities

• Perform work somewhere other than an employer’s premises

• Work without frequent oversight

What are the 3 categories of tax credit?

Nonrefundable personal credits, refundable personal credits, and business credits

What are some types of nonrefundable tax credits?

child tax credit, child an dependent care credit, and education credits

How much is the base amount for the child tax credit?

Qualifying children younger than 17 who are claimed as a dependent: 2,200

Qualifying dependent other than a qualifying child under 17: 500

or

Qualifying children who are still your dependents, but 17 or older

What is the phase-out rule for child tax credits?

For every $1,000 over the threshold (on the cheat sheet), $50 of credit is phased out. Always round UP to the nearest whole dollar after dividing the excess by 1,000.

What are eligible expenditures for the child and dependent care credit

Expenditure to provide care for one or more qualifying persons

Who is a qualifying person for the child and dependent care credit

• A dependent under age 13

• A dependent or spouse who is unable to take care of themselves who lives with the taxpayer for more than half of the year

How is the credit calculated?

The amount of eligible expenditure is the lesser of the following:

• The total amount of dependent care for the year

• 3,000 for one qualifying person or 6,000 for 2 or more

• The taxpayer’s earned income

  • For married individuals, they must file MFJ, and the earned income is the earned income of the lesser-earning spouse

The credit is calculated by taking the eligible expenditure times 20% for taxpayers with an AGI>43,000

What are the requirements for the American opportunity credit

1st 4 years of college

At least halftime enrolled

What are the eligible expenses for AOC and Lifetime learning credit?

AOC: Everything, but room and board basically

LLC: Tuition and fees (to acquire or improve a taxpayer’s job skills) only, no books or rent

Is the AOC refunible?

40% of it is refundable

How are the credit amounts for AOC and LLC calculated?

AOC: 100% of the first 2,000 of eligible expenses plus 25% of the next 2,000

• Up to 2,500/person (one taxpayer could have more than one 2,500 credit)

• Subject to Pro-Rada

LLC: 20% of expenses up to $10,000

• Max credit is 2,000/taxpayer (not per person)

Could a taxpayer claim both the AOC and LLC?

Yes, but taxpayers cannot claim both credits for the same student in the same year

Is the Life-time learning credit refundable?

No

What are some examples of refundable personal credits?

• Excess FICA

• Taxes withheld on wages and estimated tax payments

What are business tax credits?

They provide incentives for taxpayers to hire certain types of individuals or to participate in certain business activities

Are business tax credits refundible?

No, but they can be carried back 1 year or forward 20 years

In what order should you use tax credits?

Nonrefundable Personal credits → Businesses → Refundle personal

What are the main two types of prepayments/

Withholdings and estimated tax payments

What are estimated tax payments

Generally for self-employed taxpayers

• Only required if withholdings are insufficient to meet taxpayer’s tax liability

When are estimated tax payments due for calendar year taxpayers?

April 15th (4/15), June 15th (6/15), September 15th (9/15), and January 15th (1/15/+1) of the following year

What are underpayment penalties?

Penalties that apply when taxpayers fail to adequately prepay their tax liability

When are their no underpayment penatlies?

When prepayments exceed 90% of their current tax liability or 100% of their previous year tax liability (110% for individuals with AGI>150,000)

Who is required to file a tax return>

Any taxpayer whose gross income exceeds certain thresholds that vary with age and filing status

• In general, thresholds are the applicable standard deduction for the different statuses