Module 4
Basic Individual Taxation
A. The Individual Income Tax Formula
Beginning with gross income, this formula is embedded in the first two pages of
the individual income tax Form 1040, the form individuals generally use to report their
taxable income.2 Exhibit 4-2 presents the first two pages of the 2017 Form 1040 edited to
replace the line on page 2 for personal and dependency exemption deductions with the
deduction for qualified business income. The 2018 tax forms, which will reflect recent
tax law changes, were unavailable at the time we went to press. The last line on page 1 of
Form 1040 is adjusted gross income (AGI), an important reference point in the income
tax formula. Let’s look at the components of the individual tax formula and provide a
brief description of each of the key elements.
The U.S. tax laws are based on the all-inclusive income concept. Under this
concept, gross income generally includes all realized income from whatever source
derived. 3 Realized income is income generated in a transaction with a second party in
which there is a measurable change in property rights between parties (for example,
appreciation in a stock investment would not represent realized income unless the
taxpayer sold the stock). Certain tax provisions allow taxpayers to permanently exclude
specific types of realized income from gross income (excluded income items are never
taxable) and other provisions allow taxpayers to defer including certain types of realized
income items in gross income until a subsequent year (deferred income items are
included in gross income in a later year). Realized income items that taxpayers
permanently exclude from taxation are referred to as exclusions. Realized income items
that taxpayers include in gross income in a subsequent year are called deferrals. Exhibit
4-3 provides a partial listing of common income items included in gross income, their
character (discussed below), and where in the text we provide more detail on each
income item. Exhibit 4-4 provides a partial listing of common exclusions and deferrals
and indicates where in the text we discuss each in more detail.
Capital gains and losses are further characterized as long-term (when the taxpayer
owns the capital asset for more than one year before selling it) or short-term (when the
taxpayer owns the capital asset for one year or less before selling it). A gain on a sale of a
capital asset is generally included in gross income. If the gain is a long-term capital gain,
it is generally taxed at a 15 percent tax rate (taxed at 20 percent for high-income
taxpayers and 0 percent for low-income taxpayers). If the gain is a short-term capital
gain, the gain is taxed as ordinary income rates. Note that even though a short-term
capital gain is taxed at ordinary rates, it is still considered to be a capital gain and not
ordinary income.
When a taxpayer sells more than one capital asset during the year, the gains and
losses are netted together. A net loss is subject to the $3,000 annual deduction limit. A
net gain may be taxed at 15, 20, or 0 percent or at the ordinary rates depending on the
outcome of the netting process and the taxpayer’s taxable income. We discuss the netting
process in detail in the Investments chapter.6 ∙ Qualified dividend: Shareholders
receiving dividends from corporations include the dividend income in gross income. If
the dividend meets the qualified dividend requirements, it is generally taxed at a rate of
15 percent (taxed at 20 percent for high-income taxpayers and 0 percent for low-income
taxpayers).7=If a dividend does not meet the qualified dividend requirement, it is taxed at
ordinary rates. Because qualified dividends (and longterm capital gains) are taxed at a
preferential tax rate (a rate lower than the ordinary income rate), qualified dividends (and
long-term capital gains) can be referred to as preferentially taxed income. While qualified
dividends are taxed at the same rate as longterm capital gains, qualified dividends are not
included in the capital gain and loss netting process. Therefore, qualified dividend is a
separate and distinct character from capital.
Deductions reduce a taxpayer’s taxable income. However, they are not necessarily
easy to come by because, in contrast to the all-inclusive treatment of income, deductions
are not allowed unless a specific tax law allows them. Thus, deductions are a matter of
legislative grace. The tax laws provide for two distinct types of deductions in the
individual tax formula: for adjusted gross income (AGI) deductions and from AGI
deductions. As indicated in the individual tax formula, gross income minus for AGI
deductions equals AGI, and AGI minus from AGI deductions equals taxable income.
Congress identifies whether the deductions are for or from AGI when it enacts new
legislation that grants deductions. The distinction between the deduction types is
particularly important because AGI is a reference point often used in determining the
extent to which taxpayers are allowed to claim certain tax benefits. For example,
taxpayers with AGI in excess of certain thresholds lose tax benefits from items such as
the child tax credit and education credits (we discuss credits below).
For AGI deductions tend to be deductions associated with business activities and
certain investing activities. Because for AGI deductions reduce AGI (deducted on page 1
of Form 1040), they are referred to as “deductions above the line.” The “line” in this case
is AGI, which is the last line on page 1 of Form 1040 (see Exhibit 4-2). Prior to 2018,
moving expenses were a common for AGI deduction. However, the recent tax law
eliminated moving expenses as a deduction for all taxpayers but members of the armed
forces. Exhibit 4-5 provides a partial listing of common for AGI deductions under new
tax law and indicates where in the text we discuss them.
From AGI deductions are commonly referred to as “deductions below the line”
because they are deducted after AGI has been determined (deducted on page 2 of Form
1040). For years prior to 2018, from AGI deductions included itemized deductions, the
standard deduction, and personal and dependency exemptions. However, beginning in
2018 the new tax law added a from AGI deduction that is generally equal to 20=percent of
a taxpayer’s qualified business income (QBI) and it eliminates the deduction for personal
and dependency exemptions. While the deduction for QBI is a from AGI deduction, it is
not an itemized deduction. Thus, beginning in 2018, individuals can deduct the QBI
deduction and either their itemized deductions or a fixed amount called the standard
deduction as from AGI deductions. Taxpayers generally deduct the higher of the standard
deduction or itemized deductions. Exhibit 4-6 identifies the primary categories of
itemized deductions.
After determining taxable income, taxpayers can generally calculate their regular
income tax liability using either a tax table or a tax rate schedule, depending on their
filing status and income level (taxpayers with taxable income under $100,000 generally
must use the tax tables).8 See Appendix D for the regular tax rate schedules. However, as
we discussed above, certain types of income included in taxable income are taxed at rates
different from those in the tables or tax rate schedules. The 2017 tax rate schedules had
seven different income tax brackets (10, 15, 25, 28, 33, 35, and 39.6 percent). The 2018
tax rate schedules also have seven different income tax brackets but the rates change for
all but the first bracket (10, 12, 22, 24, 32, 35, and 37 percent). Overall, for a given level
of taxable income, a taxpayer’s tax liability will generally be lower under the 2018 tax
rate schedules.
In addition to the individual income tax, individuals may also be required to pay
other taxes such as the alternative minimum tax (AMT) or self-employment taxes. These
taxes are imposed on tax bases other than the individual’s regular taxable income.
Furthermore, taxpayers with relatively high AGI are subject to a 3.8 percent net
investment income tax on unearned (investment) income and a .9 percent additional
Medicare tax on earned income. Individual taxpayers may reduce their tax liabilities by
tax credits to determine their total taxes payable. Like deductions, tax credits are
specifically granted by Congress and are narrowly defined. Unlike deductions, which
reduce taxable income, tax credits directly reduce taxes payable. Thus, a $1 deduction
reduces taxes payable by $1 times the marginal tax rate while a $1 credit reduces taxes
payable by $1. Common tax credits include the child tax credit [$2,000 per qualifying
child (under the age of 17 at year end), up from $1,000 per child under 2017 tax law and
a $500 credit for other qualifying dependents], the child and dependent care credit, the
earned income credit, the American opportunity credit, and the lifetime learning credit.
After calculating the total tax and subtracting their available credits, taxpayers
determine their taxes due (or tax refund) by subtracting tax prepayments from the total
tax remaining after credits. Tax prepayments include: (1) withholdings, or income taxes
withheld from the taxpayer’s salary or wages by her employer, (2) estimated tax
payments the taxpayer makes for the year (paid directly to the IRS), and (3) tax that the
taxpayer overpaid on the prior-year tax return that the taxpayer elects to apply as an
estimated payment for the current tax year instead of receiving as a refund. If tax
prepayments exceed the total tax after subtracting credits, the taxpayer receives a tax
refund (or elects to apply the refund as an estimated tax payment) for the difference. If
tax prepayments are less than the total tax after credits, the taxpayer owes additional tax
and potentially a penalty for the underpayment.
B. Dependents of the Taxpayer
For 2017, taxpayers could claim and deduct a personal exemption for themselves.
Married taxpayers filing jointly could claim and deduct two personal exemptions (one for
each spouse). Individual taxpayers could generally claim and deduct a personal
exemption for themselves (unless they qualified as a dependent of another taxpayer).
Further, to provide some tax relief for those supporting others, a taxpayer was allowed to
claim and deduct an exemption for each person who qualified as the taxpayer’s
dependent. For 2017, taxpayers could deduct (from AGI) $4,050 for each exemption they
could claim. However, under new tax law effective in 2018, the deduction for personal
and dependency exemptions is reduced to zero. Nevertheless, as mentioned previously, it
remains necessary to determine who qualifies as a dependent of the taxpayer for purposes
of determining filing status, eligibility for certain tax credits, and other taxrelated
computations.
A qualifying child must be younger than the taxpayer and either (1) under age 19
at the end of the year or (2) under age 24 at the end of the year and a full-time student.12
A person is a full-time student if she was in school full-time during any part of each of
five calendar months during the calendar year.13 An individual=of any age who is
permanently and totally disabled is deemed to have met the age test. A qualifying child
must have the same principal residence as the taxpayer for more than half the year. Time
that a child or the taxpayer is temporarily away from the taxpayer’s home because the
child or taxpayer is ill, is pursuing an education, or has other special circumstances is
counted as though the child or taxpayer were living in the taxpayer’s home.
C. Filing Status
Married couples may file tax returns jointly (married filing jointly) or separately
(married filing separately). To be married for filing status purposes, taxpayers must be
married on the last day of the year. When one spouse dies during the year, at the end of
the year the surviving spouse is considered to be married to the spouse who died unless
the surviving spouse has remarried during the year. Married couples filing joint returns
combine their income and deductions and agree to share joint and several liability for the
tax liability on the return. That is, they are both ultimately responsible for seeing that the
tax is paid.
When married couples file separately, each spouse reports the income he or she
received during the year and the deductions he or she is claiming on a tax return separate
from that of the other spouse.24 So that married taxpayers can’t file separately to gain
more combined tax benefits than they would be entitled to if they were to file jointly, tax-
related items for married filing separate (MFS) taxpayers—such as tax rate schedules and
standard deduction amounts, among others—are generally one-half what they are for
married filing joint (MFJ) taxpayers. Also, if one spouse deducts itemized deductions, the
other spouse is required to deduct itemized deductions even if his or her standard
deduction amount is more than the total itemized deductions. Thus, only in unusual
circumstances does it make economic sense for tax purposes for married couples to file
separately.
When a taxpayer’s spouse dies, the taxpayer is no longer legally married.
However, to provide tax relief for widows and widowers with dependents, taxpayers who
meet certain requirements qualify for=qualifying widow or widower filing status, also
called surviving spouse status, for up to two years after the end of the year in which the
other spouse died. Recall that for tax purposes, they are still considered to be married at
the end of the year of the spouse’s death. Taxpayers are eligible for qualifying widow or
widower filing status if they (1) remain unmarried and (2) pay over half the cost of
maintaining a household where a child who qualifies as the taxpayer’s dependent lived
for the entire year (except for temporary absences).
In certain situations a couple may be legally married at the end of the year but
living apart. Although the couple could technically file a joint tax return, this is often not
desirable from a nontax perspective, because each spouse would be assuming
responsibility for paying tax on income earned by either spouse whether it was reported
or not. However, because both spouses are married at the end of the year, their only other
option is to file under the taxunfavorable married filing separately filing status.
D. Realization and Recognition of Income
As we learned in the previous chapter, gross income is income that taxpayers
realize, recognize, and report on their tax returns for the year. In the previous chapter, we
discussed gross income in general terms. In this chapter we explain the requirements for
taxpayers to recognize gross income, and we discuss the most common sources of gross
income. Taxpayers must receive an economic benefit (i.e., receive an item of value) to
have gross income. Common examples of economic benefit include compensation for
services (compensation in the form of cash, other property, or even services received),
proceeds from property sales (typically cash, property, or debt relief), and income from
investments or business activities (such as business income, rents, interest, and
dividends). How about when a taxpayer borrows money? Is the economic benefit
criterion met? No, because when a taxpayer borrows money, the=economic benefit
received (the cash received) is completely offset by the liability the taxpayer is required
to pay in return for borrowing the funds (the debt amount plus interest).
As indicated in Reg. §1.61-(a), the tax definition of income adopts the realization
principle. Under this principle, income is realized when (1) a taxpayer engages in a
transaction with another party, and (2) the transaction results in a measurable change in
property rights. In other words, assets or services are exchanged for cash, claims to cash,
or other assets with determinable value. The concept of realization for tax purposes
closely parallels the concept of realization for financial accounting purposes. Requiring a
transaction to trigger realization reduces the uncertainty associated with determining the
amount of income, because a change in rights can typically be traced to a specific
moment in time and is generally accompanied by legal documentation.
Taxpayers who realize an economic benefit must include the benefit in gross
income unless a specific provision of the tax code says otherwise. That is, taxpayers are
generally required to recognize all realized income by reporting it as gross income on
their tax returns. However, as we describe later in this chapter, through exclusions
Congress allows taxpayers to permanently exclude certain types of income from gross
income and through deferrals it allows taxpayers to defer certain types of income from
gross income until a subsequent year. Thus, it is important to distinguish between
realized and recognized income.
A common misperception is that taxpayers must receive cash to realize and
recognize gross income. However, Reg. §1.61-(a) indicates that taxpayers realize income
whether they receive money, property, or services in a transaction. For example, barter
clubs facilitate the exchange of rights to goods and services between members, many of
whom have the mistaken belief that they need not recognize income on the exchanges.
However, when members exchange property, they realize and recognize income at the
market price, the amount that outsiders are willing to pay for the goods or services. Also,
other taxpayers who exchange or trade goods or services with each other must recognize
the value of the goods or services as income, even when they do not receive any cash.
Indeed, taxpayers have the legal and ethical responsibility to report realized income
(assuming no exclusion provision applies) no matter the form of its receipt or whether the
IRS knows the taxpayer received the income.
When taxpayers sell assets, they must determine the extent to which they include
the sale proceeds in gross income. Initially, the IRS was convinced that Congress’s all-
inclusive definition of income required taxpayers to include all sale proceeds in gross
income. Taxpayers, on the other hand, argued that a portion of proceeds from a sale
represented a return of the cost or capital investment in the underlying property, called
tax basis. The courts determined that when receiving a payment for property, taxpayers
are allowed to recover the cost of the property tax-free. Consequently, when taxpayers
sell property, they are allowed to reduce the sale proceeds by their unrecovered
investment in the property to determine the realized gain from the sale.
A refund is not typically included in gross income because it usually represents a
return of capital. For example, a refund of $1,000 on an auto purchased for $12,000
simply reduces the net cost of the vehicle to $11,000. Likewise, a $200 refund of a $700
business expense is not included in gross income but instead reduces the net expense to
$500. However, if the refund is made for an expenditure deducted in a previous year, then
under the tax benefit rule the refund is included in gross income to the extent that the
prior deduction produced a tax benefit.3 For example, suppose an individual paid a
$1,000 business expense claimed as a for AGI deduction in 2017, but $250 of the
expense was subsequently reimbursed in 2018. Because the $250 business deduction
produced a tax benefit in 2017 (reduced taxable income), the $250 refund in 2018 would
be included in income.
The application of the tax benefit rule is more complex for individuals who
itemize deductions. An itemized deduction produces a tax benefit only to the extent that
total itemized deductions exceed the standard deduction. For example, suppose an
individual’s total itemized deductions exceeded the standard deduction by $100. A refund
of $150 of itemized deductions would cause the individual’s itemized deductions to fall
$50 beneath the standard deduction. If the refund occurred in the same year as the
expense, the individual would have elected the standard deduction, and the refund would
have caused taxable income to increase by only $100 (because of the difference between
claiming the standard deduction and using the total itemized deductions that would have
been claimed in the absence of any refund). If the refund occurs the year after the
deduction is claimed, then only $100 of the $150 refund would be included in gross
income under the tax benefit rule. The $100 is added to taxable income in the year of the
refund, because this is the increment in taxable income that would have resulted if the
refund had been issued in the year the itemized deduction was claimed.
Taxpayers using the cash method of accounting may try to shift income from the
current year to the next year when they receive payments near year-end. For instance,
taxpayers may merely delay cashing a check or avoid picking up a compensation
payment until after year-end. The courts responded to this ploy by devising the
constructive receipt doctrine.5 The constructive receipt doctrine states that a taxpayer
realizes and recognizes income when it is actually or constructively received.
Constructive receipt is deemed to occur when the income has been credited to the
taxpayer’s account or when the income is unconditionally available to the taxpayer, the
taxpayer is aware of the income’s availability, and there are no restrictions on the
taxpayer’s control over the income.
The claim of right doctrine is another judicial doctrine created to address the
timing of income recognition. Specifically, this doctrine addresses when a taxpayer
receives income in one period but is required to return the payment in a subsequent
period. The claim of right doctrine states that income has been realized if a taxpayer
receives income and there are no restrictions on the taxpayer’s use of the income (e.g.,
the taxpayer does not have an obligation to repay the amount). A common example of the
claim of right doctrine is a cash bonus paid to employees based on company earnings.
Despite potentially having to repay the bonuses (for example, in the case of a “clawback”
provision that requires repayment if the company has an earnings restatement),
employees would include the bonuses in gross income in the year received because there
are no restrictions on their use of the income.
The courts developed the assignment of income doctrine to prevent taxpayers
from arbitrarily transferring the taxation on their income to others. In essence, the
assignment of income doctrine holds that the taxpayer who earns income from services
must recognize the income. Likewise, income from property, such as dividends and
interest, is taxable to the person who actually owns the income-producing property.8 For
example, interest income from a bond is taxable to the person who owns the bond during
the time the interest income accrues. Thus, to shift income from property to another
person, a taxpayer must also transfer the ownership in the property to the other person.
E. Types of Income
Now that we have a basic understanding of the general definition of gross income
and related concepts, let’s turn our attention to specific types of income subject to
taxation. Our discussion is organized around income from services, income from
property, and other sources of income. Income from labor is one of the most common
sources of gross income, and it is rarely exempt from taxation. Payments for services
including salary, wages, and fees that a taxpayer earns through services in a nonemployee
capacity are all considered income from services and so is unemployment compensation.
Income from services is often referred to as earned income because it is generated by the
efforts of the taxpayer (this also includes business income earned by a taxpayer even if
the taxpayer’s business is selling inventory).
Income from property, often referred to as unearned income, may take different
forms, such as gains or losses from the sale of property, dividends, interest, rents,
royalties, and annuities.13 The tax treatment of unearned income depends upon the type
of income and, in some circumstances, the type of transaction generating the income. For
example, as discussed in the Individual Income Tax Overview, Dependents, and Filing
Status chapter, qualified dividends and long-term capital gains are taxed at preferential
tax rates, whereas other unearned income is generally taxed at ordinary tax rates.
Likewise, while gains or losses are typically recognized in the current period, certain
types of gains and losses are postponed indefinitely. We discuss annuity income and
property dispositions briefly in the following paragraphs.
An annuity is an investment that pays a stream of equal payments over time.
Individuals often purchase annuities as a means of generating a fixed income stream
during retirement. There are two basic types of annuities: (1) annuities paid over a fixed
period and (2) annuities paid over a person’s life (for as long as the person lives). The
challenge from a tax perspective is to determine how much of each annuity payment
represents gross income (income taxed at ordinary tax rates) and how much represents a
nontaxable return of capital (return of the original investment). For both types of
annuities, the tax law deems a portion of each annuity payment as a nontaxable return of
capital and the remainder as gross income. Taxpayers use the annuity exclusion ratio to
determine the portion of each payment that is a nontaxable return of capital.
Some annuities provide payments over the lives of two people. For example, a
taxpayer may purchase an annuity that provides an annual payment each year until both
the taxpayer and the taxpayer’s spouse pass away. This type of annuity is called a joint-
life annuity. The IRS provides a separate table for determining the expected number of
payments from joint-life annuities. A taxpayer receiving a life annuity who lives longer
than his or her estimated life expectancy will ultimately receive more than the expected
number of payments. The entire amount of these “extra” payments is included in the
taxpayer’s gross income, because the taxpayer has completely recovered her investment
in the annuity by the time she receives them. If the taxpayer dies before receiving the
expected number of payments, the amount of the unrecovered investment (the initial
investment less the amounts received, which is treated as a nontaxable return of capital)
is deducted on the taxpayer’s final income tax return.
Taxpayers can realize a gain or loss when disposing of an asset. Consistent with
the return of capital principle we discussed above, taxpayers are allowed to recover their
investment in property (tax basis) before they realize any gain. A loss is realized when
the proceeds are less than the tax basis in the property. Because the return of capital
principle generally applies only to the extent of the sale proceeds, a loss does not
necessarily reduce the taxpayer’s taxable income. A loss will reduce the taxpayer’s
taxable income only if the loss is deductible.
Taxpayers may receive income from sources other than their efforts (earned
income from wages or business) and their property (unearned income such as dividends
and interest). In this section we briefly summarize other common types of gross income.
If by chance you encounter other types of income that are not specifically discussed here,
remember that the tax law is based upon the all-inclusive income concept. That is, unless
a specific provision grants exclusion or deferral, economic benefits that are realized
generate gross income. This basic understanding of the structure of our tax law (and
research skills to investigate the taxability of specific income types) will serve you well
as you evaluate whether realized income should be included in gross income.
Individuals may invest in various business entities. The type of entity for tax
purposes for a business affects how the income generated by the business is taxed. For
example, income earned by a corporation (other than an S corporation) is taxed at the
entity level as opposed to the owner level. In contrast, the income and deductions from a
flow-through entity, such as a partnership or S corporation (a corporation electing S
corporation status), “flow through” to the owners of the entity (partners or shareholders).
That is, the owners report income or deductions as though they operated a portion of the
business personally. Specifically, each partner or S corporation shareholder reports his or
her share of the entity’s income and deductions, generally in proportion to his or her
ownership percentage, on his or her individual tax return.
There are three specific, narrowly defined exceptions to this rule. First, awards for
scientific, literary, or charitable achievement such as the Nobel Prize are excluded from
gross income, but only if (1) the recipient was selected without any action on his part to
enter the contest or proceeding, (2) the recipient is not required to render substantial
future services as a condition to receive the prize or award, and (3) the payer of the prize
or award transfers the prize or award to a federal, state, or local governmental unit or
qualified charity such as a church, school, or charitable organization designated by the
taxpayer.21 The obvious downside of this exception is that the award recipient does not
actually get to receive or keep the cash from the award. However, for tax purposes it is
more beneficial for the recipient to exclude the award from income entirely by
immediately transferring it to a charitable organization than it is to receive the award,
recognize the income, and then contribute funds to a charity for a charitable deduction.
Besides realizing direct economic benefits like wages and interest, taxpayers
sometimes realize indirect economic benefits that they must include in gross income as
imputed income. Bargain purchases (such as goods sold by an employer to an employee
at a discount) and below-market loans (such as a loan from an employer to an employee
at a zero or unusually low interest rate) are two common examples of taxable indirect
economic benefits. Both bargain purchases and below-market loans generally result in tax
consequences (such as gross income or taxable gifts) if the purchase or loan transaction is
not an “arms-length” transaction (such as transactions between an employer and
employee, owner and entity, or among family members).
F. Exclusion Provisions
So far in this chapter, we’ve discussed various types of income taxpayers must
realize and recognize by reporting it on their tax returns in the current year. However,
there are specific types of income that taxpayers realize but are allowed to permanently
exclude from gross income or temporarily defer from gross income until a subsequent
period. As we discussed in the previous chapter, exclusions and deferrals are the result of
specific congressional action and are narrowly defined. Because taxpayers are not
required to recognize income that is excluded or deferred, we refer to tax laws allowing
exclusions or deferrals as nonrecognition provisions. Nonrecognition provisions result
from various policy objectives. In very general terms, Congress allows most exclusions
and deferrals for two primary reasons: (1) to subsidize or encourage particular activities
or (2) to be fair to taxpayers (such as mitigating the inequity of double taxation). Our
discussion in this chapter focuses on exclusions.
Because exclusion provisions allow taxpayers to permanently remove certain
income items from their tax base, they are particularly taxpayer-friendly. We begin by
introducing three common exclusion provisions, the exclusions of municipal bond
interest, gain on the sale of a personal residence, and fringe benefits. We continue with a
survey of other exclusion provisions based on their underlying purpose: education,
double taxation, and sickness and injury. The most common example of an exclusion
provision is the exclusion of interest on municipal bonds. Municipal bonds include bonds
issued by state and local governments located in the United States, and this exclusion is
generally recognized as a subsidy to state and local governments (the exclusion allows
state and local governments to offer bonds at a lower before-tax interest rate). In contrast,
interest on U.S. government obligations (such as Treasury bills) is taxable for federal tax
purposes but is tax-exempt for state and local tax purposes.
The tax law provides several provisions that encourage or subsidize home
ownership, and the exclusion of the gain on the sale of a personal residence is a common
example of one such provision. Specifically, taxpayers meeting certain home ownership
and use requirements can permanently exclude up to $250,000 ($500,000 if married filing
jointly) of realized gain on the sale of their principal residence.38 Gain in excess of the
excludable amount generally qualifies as long-term capital gain subject to tax at
preferential rates. To satisfy the ownership test, the taxpayer must have owned the
residence (house, condominium, trailer, or houseboat) for a total of two or more years
during the five-year period ending on the date of the sale. To satisfy the use test, the
taxpayer must have used the property as her principal residence for a total of two or more
years (noncontiguous use is permissible) during the five-year period ending on the date of
the sale. The tax law limits each taxpayer to one exclusion every two years. Married
couples filing joint returns are eligible for the full $500,000 exclusion if either spouse
meets the ownership test and both spouses meet the principal-use test. However, if either
spouse is ineligible for the exclusion because he or she personally used the $250,000
exclusion on another home sale during the two years before the date of the current sale,
the couple’s available exclusion is reduced to $250,000.
In addition to paying salary and wages, many employers provide employees with
fringe benefits. For example, an employer may provide an employee with an automobile
to use for personal purposes, pay for an employee to join a health club, pay for an
employee’s moving expenses, or pay for an employee’s home security. In general, the
value of these benefits is included in the employee’s gross income as compensation for
services. However, certain fringe benefits, called “qualified” fringe benefits, are excluded
from gross income.40 Exhibit 5-3 lists some of the most common fringe benefits
excluded from an employee’s gross income. In addition to offering excluded fringe
benefits, many employers make contributions to retirement plans on behalf of their
employees. Subject to specific rules that we discuss in the Retirement Savings and
Deferred Compensation chapter, these contributions (as well as employee contributions
from salary) are not currently included in the employee’s gross income but are deferred
until the employee withdraws the contributions and related earnings from the plan.
College students seeking a degree can exclude from gross income scholarships
(including Pell grants) that pay for tuition, fees, books, supplies, and other equipment
required for the student’s courses.43 Any excess scholarship amounts (such as for room
or board) are fully taxable. The scholarship exclusion applies only if the recipient is not
required to perform services in exchange for receiving the scholarship. “Scholarships”
that represent compensation for past, current, or future services are fully taxable.
However, tuition waivers or reductions provided by an educational institution for
undergraduate courses for student employees or for graduate courses for teaching or
research assistants are not taxable. What about athletic scholarships? Good question. The
IRS has ruled that the value of athletic scholarships is excludable from gross income if it:
(1) is awarded to students by a university that expects but does not require the students to
participate in a particular sport; (2) requires no particular activity in lieu of participation;
and (3) is not canceled if the student cannot participate.44 Like other scholarships,
athletic scholarships are only excludable from gross in come to the extent they pay for
tuition, fees, books, supplies, and other equipment required for the student’s courses. Any
excess amount (for example, for room and board) is taxable.
Taxpayers are allowed to exclude from gross income earnings on investments in
qualified education plans such as 529 plans and Coverdell education savings accounts as
long as they use the earnings to pay for qualifying educational expenditures. With 529
plans, parents, grandparents, and other individuals are allowed to contribute up to the
maximum allowed by state-sponsored 529 plans to fund the qualified educational costs of
future college students and, subject to limitations, educational costs of students at public,
private, or religious elementary or secondary schools.45 Earnings in 529 plans are
distributed tax-free provided they are used for qualified higher-education expenses (no
annual limit) or tuition expense attributable to public, private, or religious elementary or
secondary schools (subject to a $10,000 limit per beneficiary per year). Qualified higher
education expenses include tuition, books, supplies, required equipment and supplies,
computer equipment and software, and reasonable room and board costs attending a
higher education institution. If, on the other hand, distributions are made to the
beneficiary for other purposes or exceed the $10,000 limit for tuition expenses
attributable to public, private, or religious elementary or secondary schools, the earnings
distributed are taxed to the beneficiary at the beneficiary’s tax rate and are subject to an
additional 10 percent penalty, while distributions of the original investment
(contributions) to the beneficiary are treated as gifts.46 Similarly, distributions to
contributors (e.g., parents, grandparents) that represent earnings on their contributions are
included in contributors’ gross income and are also subject to the 10 percent penalty.
The federal government issues bonds that allow taxpayers to acquire the bonds at
a discount and redeem the bonds for a fixed amount over stated time intervals. These
bonds don’t generate any cash in the form of interest until the taxpayer redeems the bond.
At redemption, the amount of the redemption price in excess of the acquisition price is
interest included in gross income.48 U.S. Series EE bonds fall into this category.
However, an exclusion is available for interest from Series EE bonds. This exclusion
requires that the redemption proceeds be used to pay for higher-education expenses of the
taxpayer, the taxpayer’s spouse, or a dependent of the taxpayer. Qualified higher-
education expenses include the tuition and fees required for enrollment or attendance at
an eligible educational institution. Taxpayers may also exclude the interest income if they
contribute the proceeds to a qualified tuition program.
Individuals may transfer property to other taxpayers without receiving or
expecting to receive value in return. If the transferor is alive at the time of the transfer,
the property transfer is called a gift. If the property is transferred from the decedent’s
estate (the transferor is deceased), it is called an inheritance. These transfers are generally
subject to a federal transfer tax, not the income tax. Gifts are typically subject to the
federal gift tax and inheritances are typically subject to a federal estate tax.51 Thus, gift
and estate taxes are imposed on transfer of the property and not included in income by the
recipient. The exclusion of gifts and inheritances from income taxation avoids the
potential double taxation (transfer and income taxation) on these transfers.
In some ways, life insurance proceeds are similar to inheritances. When the owner
of the life insurance policy dies, the beneficiary receives the death benefit proceeds. The
decedent (or the decedent’s estate) is generally subject to estate taxation on the amount of
the insurance proceeds. In order to avoid potential double taxation on the life insurance
proceeds, the tax laws allow taxpayers receiving life insurance proceeds to exclude the
proceeds from gross income.52 However, when the insurance proceeds are paid over a
period of time rather than in a lump sum, a portion of the payments represents interest
and must be included in gross income. In addition, the life insurance proceeds exclusion
generally does not apply when a life insurance policy is transferred to another party for
valuable consideration. In this case, the eventual life insurance proceeds collected by the
purchaser are excluded up to the sum of the purchase price of the policy and any
subsequent premiums, with remaining proceeds taxable as ordinary income.
U.S. citizens are subject to tax on all income whether it is generated in the United
States or in foreign countries. Because most foreign countries also impose tax on income
earned within their borders, U.S. citizens could be subject to both U.S. and foreign
taxation on income earned abroad. To provide relief from this potential double taxation,
Congress allows taxpayers to exclude foreign-earned income (income from foreign
sources for personal services performed) up to an annual maximum amount. Income from
pensions, annuities, salary paid by the U.S. government, or deferred compensation does
not qualify for the exclusion. The maximum exclusion is indexed for inflation, and in
2018 the maximum is $103,900. Rather than claim this exclusion, taxpayers may deduct
foreign taxes paid as itemized deductions or they may claim the foreign tax credit for
foreign taxes paid on their foreign-earned income.
Historically, the question of which payments associated with a personal injury
were excludable was controversial. In 1996 Congress settled the matter by deciding that
all payments associated with compensating a taxpayer for a physical injury (including
payments for past, current, and future lost wages) are excluded from gross income. That
is, the tax laws specify that any compensatory damages on account of a physical injury or
physical sickness are nontaxable. Thus, damages taxpayers receive for emotional distress
associated with a physical injury are excluded.
The exclusion provisions for disability insurance are more restrictive than those
for workers’ compensation payments or reimbursements from a health and accident
insurance plan. Disability insurance, sometimes called wage replacement insurance, pays
the insured individual for wages lost when the individual misses work due to injury or
disability. If an individual purchases disability insurance directly, the cost of the policy is
not deductible, but any disability benefits are excluded from gross income. Disability
insurance may also be purchased on an individual’s behalf by an employer. The employer
may allow employees to choose whether the premiums paid on their behalf are to be
considered taxable compensation or a nontaxable fringe benefit. If the premiums are
taxable compensation to the employee, the policy is considered to have been purchased
by the employee. If the premium paid for by the employer is a nontaxable fringe benefit
to the employee, the policy is considered to have been purchased by the employer. This
distinction is important because only payments taxpayers receive from an employee-
purchased policy are excluded from their gross income. If the employer pays the
premiums for an employee as a nontaxable fringe benefit, the employee must include all
disability benefits in gross income.
G. Deductions for AGI
As a matter of equity, Congress allows taxpayers involved in business activities to
deduct expenses incurred to generate business income. That is, because taxpayers include
the revenue they receive from doing business in gross income, they should be= allowed to
deduct against gross income the expenses they incur to generate those=revenues. To
begin, we must define “business activities” and, for reasons we discuss below, we must
distinguish business activities from investment activities. In general, for tax purposes,
activities are either profit-motivated or motivated by personal objectives. Profit-
motivated activities are, in turn, classified as either (1) business activities or
(2)=investment activities. Business activities are sometimes referred to as a trade or
business, and these activities require a relatively high level of involvement or effort.
The distinction between business and investment activities is critical for
determining whether a deduction associated with the activity is above or below the line or
even deductible. With one exception, business expenses are deducted for AGI. The lone
exception is unreimbursed employee business expenses, which, unfortunately, are not
deductible for years beginning after 2017.4 In contrast, investment-related expenses, if
deductible at all, are deductible as itemized deductions with one exception. Expenses
associated with rental and royalty activities are deductible for AGI regardless of whether
the activity qualifies as an investment or a business. Exhibit 6-1 summarizes the rules for
classifying business and investment-related expenses as for AGI deductions, from AGI
deductions, or not deductible.
Congress limits business deductions to expenses directly related to the business
activity and those that are ordinary and necessary for the activity.5 This means that
deductible expenses must be appropriate and helpful for generating a profit. Although
business deductions are one of the most common deductions for AGI, they are not readily
visible on the front page of Form 1040. Instead, these deductions are reported with
business revenues on Schedule C of Form 1040. Schedule C, presented in Exhibit 6-2, is
essentially an income statement for the business that identifies typical ordinary and
necessary business expenses.
Taxpayers are allowed to deduct their expenses associated with generating rental
or royalty income for AGI.6= Like business expenses, rental and royalty expenses do not
appear directly on the front page of Form 1040. Instead, rental and royalty deductions are
reported with rental and royalty revenues on Schedule E of Form 1040.7 Schedule E,
presented in Exhibit 6-3, is essentially an income statement for the taxpayer’s rental or
royalty activities. Taxpayers transfer the net income or loss from Schedule E to Form
1040 (page 1), line 17. Rental and royalty endeavors are most commonly considered to be
investment activities, but like trade or business expenses, rental and royalty deductions
are claimed above the line.8 Perhaps rental and royalty expenses are deductible for AGI
because Congress believed that these activities usually require more taxpayer
involvement than other types of investment activities. Despite this preferential treatment,
the deductibility of rental losses (where expenses exceed income) is subject to limitations
(basis, at-risk, passive loss, and excess business loss rules). We discuss the excess
business loss rules later in this chapter and the basis, at-risk, and passive loss rules in the
Investments chapter when we discuss similar limitations that apply to investments in
flow-through entities.
For years beginning after 2017, taxpayers are not allowed to deduct an “excess
business loss” for the year. Rather, excess business losses are carried forward to
subsequent years as a net operating loss carryforward. The excess business loss limitation
applies to losses that are otherwise deductible under the basis, at-risk, and passive loss
rules. An excess business loss for the year is the excess of aggregate business deductions
for the year over the sum of aggregate business gross income or gain of the taxpayer plus
a threshold amount. The threshold amount for 2018 is $500,000 for married taxpayers
filing jointly and $250,000 for other taxpayers. The threshold amounts are indexed for
inflation. In the case of partnership or S corporation business losses, the provision applies
at the partner or shareholder level.
The cost of health insurance is essentially a personal expense. However,
employers often pay a portion of health insurance premiums for employees as a qualified
fringe benefit. Employers are allowed to deduct health insurance premiums as
compensation expense, while employees are allowed to exclude these premiums from
gross income. The health insurance fringe benefit does not apply to self-employed
taxpayers because they are not “employees.” So to provide equitable treatment, Congress
allows self-employed taxpayers to claim personal health insurance premiums for the
taxpayer, the taxpayer’s spouse, the taxpayer’s dependents, and the taxpayer’s children
under age 27 (regardless of whether the child is a dependent of the taxpayer) as
deductions for AGI, but only to the extent of the self-employment income derived from
the specific trade or business.
H. Itemized Deductions
There are a variety of itemized deductions. Many itemized deductions are
personal in nature but are allowed to subsidize desirable activities such as home
ownership and charitable giving. Other itemized deductions, such as medical expenses,
provide relief for taxpayers whose ability to pay taxes has been involuntarily reduced. We
discuss itemized deductions in the order they appear on the individual tax return, Form
1040, Schedule A.
Taxpayers may deduct the cost of meals and lodging at hospitals. However, the
cost of meals and lodging at other types of facilities such as nursing homes are deductible
only when the principal purpose for the stay is medical care rather than convenience.22
Of course, taxpayers may deduct the costs of actual medical care whether the care is
provided at hospitals or other long-term care facilities. The deduction for medical
expenses is limited to the amount of unreimbursed qualified medical expenses paid
during the year (no matter when the services were provided) reduced by 7.5 percent of
the taxpayer’s AGI for 2017 and 2018 (and 10 percent thereafter). This restriction is
called a floor limitation because it eliminates any deduction for amounts below the floor.
The purpose of a floor limitation is to restrict a deduction to taxpayers with substantial
qualified expenses. Because this floor limitation is set at a high percentage of AGI,
unreimbursed medical expenses rarely produce tax benefits, especially for high-income
taxpayers.
There are two itemized deductions for interest expense.25 First, subject to
limitations described in more detail in the Tax Consequences of Home Ownership
chapter, individuals can deduct interest paid on acquisition indebtedness secured by a
qualified residence (the taxpayer’s principal residence and one other residence).26
Acquisition indebtedness is any debt secured by a qualified residence that is incurred in
acquiring, constructing, or substantially improving the residence. The home mortgage
interest deduction is limited by a cap on acquisition indebtedness that varies based upon
when the indebtedness originated. For acquisition indebtedness incurred after December
15, 2017, taxpayers may only deduct mortgage interest on up to $750,000 of acquisition
indebtedness ($375,000 if married filing separately). For acquisition indebtedness
incurred before December 16, 2017, the limitation on acquisition indebtedness is
$1,000,000 ($500,000 if filing married separate), even if the debt is refinanced after
December 15, 2017. When a taxpayer has both acquisition indebtedness incurred before
December 16, 2017, and after December 15, 2017, the $750,000 ($375,000) limit is
reduced (not below zero) by the acquisition indebtedness incurred before December 16,
2017.
Cash contributions are deductible in the year paid, including donations of cash or
by check, electronic funds transfers, credit card charges, and payroll deductions.31
Taxpayers are also considered as making monetary contributions for the cost of
transportation and travel for charitable purposes if there is no significant element of
pleasure or entertainment in the travel. When taxpayers use their personal vehicles for
charitable transportation purposes, they may deduct, as a cash contribution, a standard
mileage allowance for each mile driven (14 cents a mile in 2018). While taxpayers are
allowed to deduct their transportation costs and other out-of-pocket costs of providing
services for charities, they are not allowed to deduct the value of the services they
provide for charities.
I. The Standard Deduction
The standard deduction is a flat amount that most individuals can elect to deduct
instead of deducting their itemized deductions (if any). That is, taxpayers generally
deduct the greater of their standard deduction or their itemized deductions. The amount of
the standard deduction varies according to the taxpayer’s filing status, age, and eyesight.
The basic standard deduction is greater for married taxpayers filing jointly and those
supporting a family (head of household) than it is for married taxpayers filing separately
and unmarried taxpayers not supporting a family. Taxpayers who are at least 65 years of
age on the last day of the year or are blind are entitled to additional standard deduction
amounts above and beyond their basic standard deduction.40 Exhibit 6-10 summarizes
the standard deduction amounts. With significantly larger standard deduction amounts in
2018, many more taxpayers are expected now to deduct the standard deduction instead of
deducting itemized deductions.
From the government’s standpoint, the standard deduction serves two purposes.
First, to help taxpayers with lower income, it automatically provides a minimum amount
of income that is not subject to taxation. Second, it eliminates the need for the IRS to
verify and audit itemized deductions for those taxpayers who choose to deduct the
standard deduction. From the taxpayers’ perspective, the standard deduction allows them
to avoid taxation on a portion of their income, and for those not planning to itemize
deductions, it eliminates the need to substantiate and collect information about them.= The
standard deduction, however, is a double-edged sword. While it reduces taxes by
offsetting income with an automatic deduction, it eliminates the tax benefits of itemized
deductions up to the amount of the standard deduction. This is a very important point to
consider when evaluating the tax benefits of itemized deductions.
Some taxpayers may deduct the standard deduction every year because their
itemized deductions always fall just short of the standard deduction amount and thus
never produce any tax benefit. They may gain some tax benefit from their itemized
deductions by implementing a simple tax planning strategy called bunching itemized
deductions. The basic strategy consists of shifting itemized deductions into one year such
that the amount of itemized deductions exceeds the standard deduction for the year, and
then deducting the standard deduction in the next year (or vice versa). Because
individuals are cash-method taxpayers, they may shift certain itemized deductions by
accelerating payment into the current year. For example, a taxpayer could make
charitable contributions at the end of December rather than at the beginning of January in
the following year. Taxpayers’ ability to shift itemized deductions is limited because the
timing of these payments is not completely discretionary. For example, real estate taxes
have due dates, state taxes are generally paid throughout the year via withholding, and
employees may incur and be required to pay business expenses throughout the year.
However, taxpayers who annually make a certain amount of charitable contributions, for
example, may consider lumping contributions for two years into one year and not
contributing in the next year.
J. Deduction for Qualified Business Income
A qualified trade or business is any trade or business other than a specified service
trade or business and other than the trade or business of being an employee. A specified
service trade or business is any trade or business involving the performance of services in
the fields of health, law, consulting, athletics, financial services, brokerage services, or
any trade or business where the principal asset of such trade or business is the reputation
or skill of one or more of its employees or owners, or which involves the performance of
services that consist of investing and investment management trading, or dealing in
securities, partnership interests, or commodities. Architecture and engineering services
(their services build things) are specifically excluded from the definition of specified
service trade or business.
For purposes of the wage-based limit, each partner or S corporation shareholder is
treated as having wages for the year equal to his or her allocable share from the
partnership or S corporation. The wage-based limits only apply to taxpayers with taxable
income in excess of $157,500 ($315,000, in the case of a joint return)). The wage limit is
phased in ratably over $50,000 ($100,000 for married filing joint returns) so that it fully
applies to taxpayers with taxable income in excess of $207,500 ($415,000 for married
filing joint return).
We then determined their from AGI deductions. Courtney deducted her itemized
deductions because they exceeded her standard deduction. Gram, on the other hand,
deducted her standard deduction. Finally, Courtney was able to take advantage of the
deduction for qualified business income, while Gram did not have any qualified business
income. By subtracting their from AGI deductions from their AGI, we determined
taxable income for both Courtney and Gram. With this knowledge, we proceed to the
next two chapters and address issues relating to investments and determining the amount
of tax Courtney and Gram are required to pay on their taxable income.
K. Regular Federal Income Tax Computation
As we described in the Introduction to Tax chapter, a tax rate schedule is
composed of several ranges of income taxed at different (increasing) rates. Each separate
range of income subject to a different tax rate is referred to as a tax bracket. While each
filing status has its own tax rate schedule (married filing jointly and qualifying widow or
widower use the same rate schedule), all tax rate schedules consist of tax brackets taxed
at 10 percent, 12 percent, 22 percent, 24 percent, 32 percent, 35 percent, and 37 percent.
However, the width or range of income within each bracket varies by filing status. In
general, the tax brackets are widest and higher levels of income are taxed at the lowest
rates for the married filing jointly filing status, followed by the head of household filing
status, single filing status, and finally, the married filing separately filing status.
An interesting artifact of the tax rate schedules is that they can impose what some
refer to as a marriage penalty, but they may actually produce a marriage benefit. A
marriage penalty (benefit) occurs when, for a given level of income, a married couple
incurs a greater (lesser) tax liability by using the married filing jointly tax rate schedule to
determine the tax on their joint income than they would have owed (in total) if each
spouse had used the single tax rate schedule to compute the tax on their individual
incomes. Exhibit 8-1 explores the marriage penalty in a scenario in which both spouses
earn income and another in which only one spouse earns income. As the exhibit
illustrates, the marriage penalty applies to couples with two wage earners with high
incomes, but a marriage benefit applies to couples with single breadwinners. For couples
with two wage earners with moderate to low incomes, there is typically not a marriage
penalty.
Parents can reduce their family’s income tax bill by shifting income that would
otherwise be taxed at their higher tax rates to their children whose income is taxed at
lower rates. However, as we described in the Gross Income and Exclusions chapter,
under the assignment of income doctrine, taxpayers cannot simply assign or transfer
income to other parties. Earned income, or income from services or labor, is taxed to the
person who earns it. Thus, it’s difficult for a parent to shift earned income to a child.
However, unearned income or income from property such as dividends from stocks or
interest from bonds is taxed to the owner of the property. Thus, a parent can shift
unearned income to a child by transferring actual ownership of the incomeproducing
property to the child. By transferring ownership, the parent runs the risk that the child
will sell the asset or use it in a way unintended by the parent. However, this risk is
relatively small for parents transferring property ownership to younger children.
L. Alternative Minimum Tax
Each year, a number of taxpayers are required to pay the alternative minimum tax
(AMT) in addition to their regular tax liability. The alternative minimum tax system was
implemented in 1986 (earlier variations date back to the late 1960s) to ensure that
taxpayers generating income pay some minimum amount of income tax each year. After
several years in which a large number of taxpayers were subject to AMT, 2017 tax law
changes were designed to reduce the number of taxpayers subject to AMT. The tax is
targeted at higher-income taxpayers who are benefiting from or are perceived by the
public to be benefiting from the excessive use (more than Congress intended) of tax
preference items such as exclusions, deferrals, and deductions to reduce or even eliminate
their tax liabilities.
In general terms, the alternative minimum tax is a tax on an alternative tax base
meant to more closely reflect economic income than the regular income tax base. Thus
the alternative minimum tax (AMT) base is more inclusive (or more broadly defined)
than is the regular income tax base. To compute their AMT, taxpayers first compute their
regular income tax liability. Then they compute the AMT base and multiply the base by
the applicable alternative tax rate.9 They must pay the AMT only when the tax on the
AMT base exceeds their regular tax liability.
Regular taxable income is the starting point for determining the alternative
minimum tax. As the AMT formula in Exhibit 8-2 illustrates, taxpayers make several
“plus” and “minus” adjustments to regular taxable income to compute alternative
minimum taxable income (AMTI). They then arrive at the AMT base by subtracting an
AMT exemption from AMTI. Taxpayers multiply the AMT base by the AMT rate to
determine their tentative minimum tax. Finally, to determine their alternative minimum
tax, taxpayers subtract their regular tax liability from the tentative minimum tax. The
alternative minimum tax is the excess of the tentative minimum tax over the regular tax.
If the regular tax liability equals or exceeds the tentative minimum tax, taxpayers need
not pay any AMT.
M. Employment and Self-Employment Taxes
As we discussed in the Introduction to Tax chapter, employees and self-employed
taxpayers must pay employment (or self-employment) taxes known as FICA taxes.14
The FICA tax consists of a Social Security and a Medicare component that are payable
by both employees and employers. The Social Security tax is intended to provide basic
pension coverage for the retired and disabled. The Medicare tax helps pay medical
costs for qualified individuals. Because Social Security and Medicare taxes are paid by
working taxpayers but received by retired taxpayers, Social Security and Medicare
taxes represent intergenerational transfers. The Social Security tax rate is 12.4 percent
on the tax base (limited to $128,400 in 2018), and the Medicare tax rate is 2.9 percent
on the tax base. An additional Medicare tax of .9 percent applies on the tax base in
excess of $200,000 ($125,000 for married filing separately; $250,000 for married filing
jointly). Below we discuss these taxes apply for employees, employers, and self-
employed taxpayers.
Both employees and employers have to pay FICA taxes on employee salary,
wages, and other compensation paid by employers. The Social Security tax rate for
employees is 6.2=percent of their salary or wages (wage base limited to $128,400 in
2018), the Medicare tax rate for employees is 1.45 percent of their salary or wages, and
the additional Medicare tax rate is .9 percent on salary or wages in excess of $200,000
($125,000 for married filing separate; $250,000 of combined salary or wages for
married filing joint). Employers withhold the employees’ FICA tax liabilities from the
employees’ paychecks for both the Social Security tax and the Medicare tax. For the
additional Medicare tax, employers are required to withhold the tax at a rate of .9
percent for any salary or wages above $200,000, irrespective of the taxpayer’s filing
status (e.g., single, married filing separate, married filing joint, or head of
household).15 Taxpayers use Form 8959 to determine their liability for the additional
Medicare tax and report all of the additional Medicare tax withheld as a tax payment on
Form 1040.
While employees share their FICA (Social Security and Medicare) tax burden
with employers, self-employed taxpayers must pay the entire FICA tax burden on their
selfemployment earnings.16 Like FICA taxes for employees, self-employment taxes
consist of both Social Security and Medicare taxes. Because their FICA taxes are based
on their self-employment earnings, FICA taxes for self-employed taxpayers are
referred to as self-employment taxes. The base for the Social Security component of
the self-employment tax is limited to $128,400. The base for the Medicare portion of
the self-employment tax is unlimited. Taxpayers use Schedule SE to determine their
Social Security tax and 2.9=percent Medicare tax on self-employment earnings, and
they use Form 8959 to determine the additional Medicare tax on self-employment
earnings. Although applied to self-employment earnings, the additional Medicare tax is
not considered technically a part of the self-employment tax.
N. Tax Credits
Congress provides a considerable number of credits for taxpayers. Tax credits
reduce a taxpayer’s tax liability dollar for dollar. In contrast, deductions reduce taxable
income dollar for dollar, but the tax savings deductions generated depend on the
taxpayer’s marginal tax rate. Because tax credits generate tax savings independent of a
taxpayer’s marginal tax rate, they are a popular tax policy tool for avoiding the
perception that tax benefits for certain tax policies are distributed disproportionately to
taxpayers with higher incomes and corresponding higher marginal tax rates. Further,
tax credits are powerful tax policy tools because they directly affect taxes due. By
using tax credits, policy makers can adjust the magnitude of the tax effects of tax
policy without changing tax rates.
Tax credits can be either nonrefundable or refundable. A nonrefundable credit
may reduce a taxpayer’s gross tax liability to zero, but if the amount of the credit
exceeds the amount of the taxpayer’s gross tax liability, the credit in excess of the gross
tax liability is not refunded to the taxpayer. It expires without ever providing tax
benefits, unless it can be carried over to a different year. Refundable credits in excess
of a taxpayer’s gross tax liability are refunded to the taxpayer. Tax credits are generally
classified into one of three categories: nonrefundable personal, refundable personal, or
business credits, depending on the nature of the credit. The primary exception to this
general rule is the foreign tax credit. The foreign=tax credit is a hybrid between
personal and business credits because, like nonrefundable personal credits, it reduces
the taxpayer’s liability before business credits but, like business credits, unused foreign
tax credits can be carried over to use in other years.
Congress provides many nonrefundable personal tax credits to generate tax relief
for certain groups of individuals. For example, the child tax credit (partially
refundable) provides tax relief for taxpayers who provide a home for dependent
children, and the child and dependent care credit provides tax relief for taxpayers who
incur expenses to care for their children and other dependents in order to work. The
American opportunity credit (partially refundable) and the lifetime learning credit help
taxpayers pay for the cost of higher education. Because the child tax credit, the child
and dependent care credit, and the American opportunity and lifetime learning credits
are some of the most common nonrefundable personal credits, we discuss them in
detail.
The child and dependent care credit is a tax subsidy to help taxpayers pay the cost
of providing care for their dependents to allow taxpayers to work or look for work. The
amount of the credit is based on the amount of the taxpayer’s expenditures to provide
care for one or more qualifying persons. A qualifying person includes (1) a dependent
under the age of 13, and (2) a dependent or spouse who is physically or mentally
incapable of caring for herself or himself and who lives in the taxpayer’s home for
more than half the year.
The earned income credit is a refundable credit that is designed to help offset the
effect of employment taxes on compensation paid to lowincome taxpayers and to
encourage lower-income taxpayers to seek employment. Because it is refundable (if the
credit exceeds the tax after considering nonrefundable credits, the taxpayer receives a
refund for the excess), it is sometimes referred to as a negative income tax. The credit
is available for qualified individuals who have earned income for the year.34 Qualified
individuals generally include (1) those who have at least one qualifying child (same
definition of qualifying child for dependent purposes—see the Individual Income Tax
Overview, Dependents, and Filing Status chapter) and (2) those who do not have a
qualifying child for the taxable year but who live in the United States for more than
half the year, are at least 25 years old but younger than 65 years old at the end of the
year, and are not a dependent of another taxpayer. Earned income includes wages,
salaries, tips, and other employee compensation included in gross income and net
earnings from self-employment. Taxpayers with investment income such as interest,
dividends, and capital gains in excess of $3,500 are ineligible for the credit.
Business tax credits are designed to provide incentives for taxpayers to hire
certain types of individuals or to participate in certain business activities. For example,
Congress provides the employment tax credit to encourage businesses to hire certain
unemployed individuals, and it provides the research and development credit to
encourage businesses to expend funds to develop new technology. Business tax credits
are nonrefundable credits. However, when business credits other than the foreign tax
credit (discussed below) exceed the taxpayer’s gross tax for the year, the credits are
carried back one year and forward 20 years to use in years when the taxpayer has
sufficient gross tax liability to use them.
As we’ve discussed, credits are applied against a taxpayer’s gross tax. However,
we still must describe what happens when the taxpayer’s allowable credits exceed the
taxpayer’s gross tax. Keep in mind that nonrefundable personal credits and business
credits may be used to reduce a taxpayer’s gross tax to zero, but not below zero.38 In
contrast, by definition, a refundable credit may reduce a taxpayer’s gross tax below
zero. This excess refundable credit generates a tax refund for the taxpayer. When a
nonrefundable personal credit exceeds the taxpayer’s gross tax, it reduces the gross tax
to zero, but the excess credit (credit in excess of the taxpayer’s gross tax) disappears.
That is, the taxpayer may not carry over any excess nonrefundable personal credits to
use in other years. However, when a business credit or foreign tax credit exceeds the
gross tax, it reduces the taxpayer’s gross tax to zero, but the excess credit may be
carried forward or back to be used in other years when the taxpayer has sufficient gross
tax to use the credit (subject to certain time restrictions discussed above).
O. Taxpayer Prepayments and Filing Requirements
The income tax must be paid on a pay-as-you-go basis. This means it must be
prepaid via withholding from salary or through periodic estimated tax payments during
the tax year. Employees pay tax through withholding, and self-employed taxpayers
generally pay taxes through estimated tax payments. Employers are required to
withhold taxes from an employee’s wages based upon the employee’s marital status,
exemptions, and estimated annual pay. Wages include both cash and noncash
remuneration for services, and employers remit withholdings to the government on
behalf of employees. At the end of the year, employers report the amounts withheld to
each employee via Form W-2. Estimated tax payments are required of employees only
if withholdings are insufficient to meet the taxpayer’s tax liability. For calendar-year
taxpayers, estimated tax payments are due on April 15, June 15, and September 15 of
the current year and January 15 of the following year. If the due date falls on a
Saturday, Sunday, or holiday, it is automatically extended to the next day that is not a
Saturday, Sunday, or holiday.
When taxpayers like Courtney fall behind on their tax prepayments, they may be
subject to an underpayment penalty.39 Taxpayers with unpredictable income streams
may be particularly susceptible to this penalty because it is difficult for them to
accurately estimate their tax liability for the year. To help taxpayers who may not be
able to predict their earnings for the year and to provide some margin of error for those
who can, the tax laws provide some safe-harbor provisions. Under these provisions
taxpayers can avoid underpayment penalties if their withholdings and estimated tax
payments equal or exceed one of the following two safe harbors: (1) 90 percent of their
current tax liability or (2) 100 percent of their previous-year tax liability (110 percent
for individuals with AGI greater than $150,000).
Individual taxpayers are required to file a tax return only if their gross income
exceeds certain thresholds, which vary based on the taxpayer’s filing status and age.
However, a taxpayer may prefer to file a tax return even when she is not required to do
so. For example, a taxpayer with gross income less than the threshold may want to file
a tax return to receive a refund of income taxes withheld. In general, the thresholds are
simply the applicable standard deduction amount for the different filing statuses.42
With the increased standard deduction amounts in 2018, fewer taxpayers are now
required to file.
The tax law imposes a late filing penalty on taxpayers who do not file a tax return
by the required date (the original due date plus extension).43 The penalty equals 5
percent of the amount of tax owed for each month (or fraction of a month) that the tax
return is late, with a maximum penalty of 25 percent. For fraudulent failure to file, the
penalty is 15 percent of the amount of tax owed per month with a maximum penalty of
75 percent. If the taxpayer owes no tax as of the due date of the tax return (plus
extension), the tax law does not impose a late filing penalty.
An extension allows the taxpayer to delay filing a tax return but does not extend
the due date for tax payments. If a taxpayer fails to pay the entire balance of tax owed
by the original due date of the tax return, the tax law imposes a late payment penalty
from the due date of the return until the taxpayer pays the tax.44 The late payment
penalty equals .5 percent of the amount of tax owed for each month (or fraction of a
month) that the tax is not paid. The combined maximum penalty that may be imposed
for late payment and late filing (nonfraudulent) is 5 percent per month (25 percent in
total). For late payment and=filing due to fraud, the combined maximum penalty for late
payment and late filing is 15 percent per month (75 percent in total).
