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Taxation of Individuals and Business Entities

Individual Income Tax

Computation and Tax Credits

2020 Edition

Chapter 8

1. Determine a taxpayer’s regular tax liability.

2. Compute a taxpayer’s alternative minimum tax liability.

3. Calculate a taxpayer’s net investment income tax, employment, and self-employment taxes.

4. Compute a taxpayer’s allowable child tax credit, child and dependent care credit, American opportunity credit, lifetime learning credit, and earned income credit.

5. Explain how to compute a taxpayer’s underpayment, late filing, and late payment penalties.

Learning Objectives

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• 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

– Progressive tax rates

 Tax rate schedules

 Tax tables

Federal Income Tax Computation (1 of 5)

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• Tax brackets or marginal tax rates on ordinary income:

– 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent

• Marriage penalty or benefit

– Who is likely to have penalty?

 Both spouses receive income.

– Who is likely to have benefit?

 One spouse receives income.

Federal Income Tax Computation (2 of 5)

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• Exceptions to ordinary tax rates

– Long-term capital gains (net capital gains)

 Generally 0, 15, or 20 percent, but can be as high as 28 percent

 Two different tax rates on one gain is possible.

– Dividends

 Qualified dividends generally taxed at 0, 15, or 20 percent.

 Two different tax rates on one dividend is possible.

Federal Income Tax Computation (3 of 5)

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• Kiddie Tax

– Net unearned income taxed at trust and estate tax rates.

 Net unearned income = unearned income in excess of $2,200

Federal Income Tax Computation (4 of 5)

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– 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.

Federal Income Tax Computation (5 of 5)

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Assume that Courtney’s taxable income is $471,700, including $15,000 of qualifying dividends taxed at the preferential rate. What would be Courtney’s tax liability under these circumstances?

Tax Computation Example

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Answer: $136,370, computed using the head of household tax rate schedule as follows:

Tax Computation Example Solution (1 of 2)

Description Amount Explanation

1) Taxable income $471,700

2) Preferentially taxed income 15,000

3) Income taxed at ordinary rates 456,700 (1) – (2)

4) Tax on income at ordinary tax rates 133,620 $45,210 + [($456,700 − $204,100) × 35%] (See tax rate schedule for head of household.)

5) Tax on preferentially taxed income 2,750 [($5,000 × 15%) + ($10,000 × 20%)]*

Tax $136,370 (4) + (5)

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*Courtney had $15,000 of preferentially taxed income. $10,000 of her dividends fall in the 20 percent preferential tax bracket ($471,700 taxable income − $461,700 end of 20 percent preferential tax bracket; see preferential tax rate schedule for head of household). The remaining $5,000 is taxed at 15 percent (15 percent bracket for preferentially tax income extends from $52,751 to $461,700 for head of household).

Tax Computation Example Solution (2 of 2)

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• 3.8 percent 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).

Net Investment Income Tax

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Suppose that during 2019, Deron received $5,100 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?

Kiddie Tax Example

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Because Deron is younger than 18 years of age at the end of the year and his net unearned income exceeds $2,200, he is potentially subject to the kiddie tax.

Kiddie Tax Example Solution (1 of 3)

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Answer: $6,200 taxable income and $970 tax liability, calculated as follows:

Kiddie Tax Example Solution (2 of 3)

Description Amount Explanation

1) Gross income/AGI $7,300 $5,100 interest from IBM bond + $2,200 interest. All unearned income.

2) Standard deduction 1,100 Minimum for taxpayer claimed as a dependent on another return (no earned income, so must use minimum). See Chapter 6.

3) Taxable income $6,200 (1) – (2)

4) Gross unearned income minus $2,200

5,100 (1) – 2,200.

5) Net unearned income $5,100 Lesser of (3) or (4).

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Kiddie Tax Example Solution (3 of 3)

Description Amount Explanation

6) Kiddie tax $ 860 [$260 + (((5) − $2,600) × 24%)], see trust and estate tax rate schedule.

7) Taxable income taxed at Deron's rate

1,100 (3) – (5).

8) Tax on taxable income using Deron's tax rates

$ 110 (7) × 10% (See single filing status, $1,100 taxable income).

Deron’s total tax liability $ 970 (6) + (8).

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EXHIBIT 8-2 Formula for Computing the Alternative Minimum Tax

Alternative Minimum Tax Formula (1 of 2)

Regular Taxable Income

Plus: Standard deduction if taxpayer deducted the standard deduction in computing regular taxable income

Plus or Minus: Other adjustments*

Alternative minimum taxable income

Minus: AMT exemption amount (if any)

Equals: Tax base for AMT

Times: AMT rate

Equals: Tentative minimum tax

Minus: Regular tax

Equals: Alternative minimum tax

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*Technically, some of these adjustments are referred to as preference items and some are referred to as adjustments. We refer to all of these items as adjustments for simplicity’s sake.

Alternative Minimum Tax Formula (2 of 2)

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

– Tax-exempt interest from private activity bonds

– State income taxes (subject to $10,000 limit)

– Real property taxes (subject to $10,000 limit)

Alternative Minimum Tax (1 of 3)

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EXHIBIT 8-5 2019 AMT Exemptions

Alternative Minimum Tax (2 of 3)

Filing Status Exemption Phase-Out Begins

at This Level of AMTI

Phase-Out Complete for This Level of

AMTI

Married filing jointly $111,700 $1,020,600 $1,467,400

Married filing separately 55,850 510,300 733,700

Head of household and single 71,700 510,300 797,100

• Exemption phased out 25 cents for each dollar over threshold.

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• 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?

– Taxpayers with large amounts of capital gains.

Alternative Minimum Tax (3 of 3)

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• Employee

– Must pay FICA taxes on compensation from employer (6.2 percent Social Security tax rate; 1.45 percent Medicare tax rate; .9 percent additional Medicare tax rate on salary or wages in excess of $200,000 ($125,000 for married filing separately; $250,000 married filing jointly))

– $132,900 limit applies to Social Security portion

– Multiple employers during year

• Employer

– Pays FICA tax on employee’s compensation (6.2 percent Social Security tax rate; 1.45 percent Medicare tax rate)

– Withholds FICA tax from employee’s paycheck

Employment FICA Taxes

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• Self-employed taxpayers

– Responsible for entire FICA tax (employee and employer share and additional Medicare tax)

– Tax base is net earnings from self-employment (Generally, net Schedule C income and multiply by .9235).

– Same $132,900 limit applies to Social Security portion.

Employment and Self- Employment Taxes (1 of 2)

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

• How does the $132,900 Social Security earnings limit apply when receiving both wages and SE earnings in the same year?

– Wages use up limit first—favorable or unfavorable for taxpayer? Why?

Employment and Self- Employment Taxes (2 of 2)

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Assume that Courtney received $100,000 of taxable compensation from EWD in 2019, and she received $180,000 in self-employment income from her weekend consulting activities. What amount of self- employment taxes and additional Medicare tax 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 additional Medicare tax.

Employment and Self- Employment Taxes Example

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Answer: $8,901 of self-employment taxes and $596 of additional Medicare tax, computed as follows:

Employment and Self-Employment Taxes Example Solution (1 of 2)

Description Amount Explanation

1) Social Security wage base limit less employee compensation subject to Social Security tax

$ 32,900 $132,900 − $100,000, limited to $0

2) Net earnings from self-employment 166,230 $180,000 × 92.35%

3) Social Security portion of self-employment tax

4,080 [Lesser of Step (1) or (2)] × 12.4%

4) Medicare tax 4,821 Step (2) × 2.9%

5) Sum of taxpayer's compensation and net earnings from self-employment

266,230 $100,000 + Step (2)

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Employment and Self-Employment Taxes Example Solution (2 of 2)

Description Amount Explanation

6) [Greater of (a) zero or (b) the amount from Step (5) minus $200,000] × 0.9%

596 66,230 × 0.9%

7) Step (6) less any additional Medicare tax withheld by Courtney's employer

596 596 – 0

8) Steps (3) + (4) + (7) 9,497 4,080 + 4,821 + 596. [$8,901 of self- employment taxes (3) + (4) and $596 of additional Medicare tax]

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• Determining whether taxpayer is employee or independent contractor

– Primary question: who has control over how, when, where work is performed?

• Tax differences

– Amount of FICA or SE taxes payable

– Deductibility of expenses

 For AGI

 From AGI

 Employer portion of self-employment taxes

Employee versus Independent Contractor

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• Reduce tax liability dollar for dollar

• Consist of three categories

– Nonrefundable personal

– Refundable personal

– Business

Tax Credits

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• Child Tax Credit

– $2,000 for each qualifying child under age 17 at end of year

 Partially refundable

– $500 for each other qualifying dependent

– Phase-out amount, not percentage

Nonrefundable Personal (1 of 6)

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• Child and Dependent Care Credit

– Dependent under age of 13 (or disabled dependent)

– Percentage of two or more qualifying persons

– Percentage qualifying expenditures

 Maximum qualifying expenditures: $3,000 for one qualifying person, $6,000 for two or more

 Credit Care percentage depends on AGI (see Exhibit 8-9)

Nonrefundable Personal (2 of 6)

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EXHIBIT 8-9 Child and Dependent Care Credit Percentage

Nonrefundable Personal (3 of 6)

If AGI is over but not over then the percentage is

$ 0 15,000 35%

15,000 17,000 34

17,000 19,000 33

19,000 21,000 32

21,000 23,000 31

23,000 25,000 30

25,000 27,000 29

27,000 29,000 28

29,000 31,000 27

31,000 33,000 26

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Nonrefundable Personal (4 of 6)

If AGI is over but not over then the percentage is

33,000 35,000 25

35,000 37,000 24

37,000 39,000 23

39,000 41,000 22

41,000 43,000 21

43,000 No limit 20

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• American opportunity credit (formerly Hope scholarship credit) – For first four years of postsecondary education

– For eligible expenses and institutions only

– Applied per student

 Taxpayer, spouse, taxpayer’s dependents

 Amounts paid by dependents treated as paid by taxpayer.

– 100 percent of first $2,000 of eligible expenses and 25% of next $2,000 (maximum credit is $2,500)

– Phase-out based on AGI

– 40 percent of credit is refundable (subject to restrictions).

Nonrefundable Personal (5 of 6)

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• Lifetime learning credit

– Eligible expenses (tuition) for postsecondary education

 Includes professional or graduate school

 Includes continuing education

– Applied per taxpayer

 MFJ return is one taxpayer.

– 20 percent of up to $10,000 of eligible expenses

– Phase-out based on AGI

Nonrefundable Personal (6 of 6)

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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 first year. What is the maximum American opportunity credit (before phase-out) Courtney may claim for these expenses?

American Opportunity Credit Example (1)

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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%].

American Opportunity Credit Example Solution (1)

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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?

American Opportunity Credit Example (2)

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Answer: $1,867, computed as follows:

American Opportunity Credit Example Solution (2)

Description Amount Explanation

1) AOC before phase-out $2,075

2) AGI 162,000

3) Phase-out threshold 160,000

4) Excess AGI 2,000 (2) − (3)

5) Phase-out range for taxpayer filing for married filing jointly

20,000 $180,000 − 160,000

6) Phase-out percentage 10% (4)/(5)

7) Phase-out amount 208 (1) × (6)

AOC after phase-out $1,867 (1) − (7)

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• 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 8-10

Refundable Personal (1 of 3)

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EXHIBIT 8-10 2019 Earned Income Credit Table

Married taxpayers filing joint returns

Refundable Personal (2 of 3)

Qualifying Children

(1) Maximum

Earned Income

Eligible for Credit

(2) Credit %

(3) Maximum

Credit (1) × (2)

(4) Credit Phase-

Out for AGI (or earned income if greater) Over

This Amount

(5) Phase-Out Percentage

No Credit When AGI (or earned income

if greater) Equals or

Exceeds This Amount

(4) + [(3)/(5)]

0 $ 6,920 7.65% $ 529 $ 14,450 7.65% $21,370

1 10,370 34 3,526 24,820 15.98 46,884

2 14,570 40 5,828 24,820 21.06 52,493

3+ 14,570 45 6,557 24,820 21.06 55,952

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All taxpayers except married taxpayers filing joint returns

Refundable Personal (3 of 3)

Qualifying Children

(1) Maximum

Earned Income Eligible

for Credit

(2) Credit %

(3) Maximum

Credit (1) × (2)

(4) Credit Phase- Out for AGI (or earned income if

greater) Over This Amount

(5) Phase-Out Percentage

No Credit When AGI (or earned

income if greater) Equals or Exceeds This

Amount (4) + [(3)/(5)]

0 $ 6,920 7.65% $ 529 $ 8,650 7.65% $15,570

1 10,370 34 3,526 19,030 15.98 41,094

2 14,570 40 5,828 19,030 21.06 46,703

3+ 14,570 45 6,557 19,030 21.06 50,162

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• 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.

Tax Credits (1 of 2)

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EXHIBIT 8-12 Credit Application

Tax Credits (2 of 2)

Credit Type Order Application Excess Credit

Nonrefundable personal First Lost

Business Second Carryback and carryover

Refundable personal Last Refunded

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• Taxes must be paid as you go.

– Withholdings

 Treated as made equally throughout the year

– Estimated tax payments

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

• Underpayment Penalties

– Safe-harbor provisions

 90 percent of current tax liability or

 100 percent of previous year’s tax liability (110% with higher AGI > $150,000) – 25% at each estimated filing deadline

Prepayments and Filing Requirements (1 of 5)

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• 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 year’s liability must be paid in by deadline (110% for taxpayers with AGI > $150,000).

– Penalty based on amount of underpayment at each quarter × federal short-term rate + 3%.

Prepayments and Filing Requirements (2 of 5)

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• 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 another’s tax return.

• Due dates

– April 15

– Extend filing up to six months

 May not extend due date for paying taxes.

Prepayments and Filing Requirements (3 of 5)

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• Late Filing Penalty

– 5 percent of tax owed per month up to 25 percent if not fraudulent; 15 percent of tax owed per month up to 75 percent if fraudulent

– No penalty if no tax is due.

• Late Payment Penalty

– If don’t pay entire tax owed by due date of return

 5 percent of amount due up to 25 percent maximum if not fraudulent

 15 percent of amount due per month up to 75 percent if fraudulent

Prepayments and Filing Requirements (4 of 5)

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

Prepayments and Filing Requirements (5 of 5)

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Assume Courtney filed her tax return on April 10 and included a check with the return for $4,073 made payable to the United States Treasury. The $4,073 consisted of her underpaid tax liability of $4,000 and her $73 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?

Late Filing and Late Payment Penalty Example

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Answer: Her combined late filing penalty and late payment penalty would be $200 ($4,000 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.

Late Filing and Late Payment Penalty Example Solution

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End of Presentation

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