Polly supports her unemployed husband Nick, stepdaughter Paige, and family friend Maude who lived with Polly. Paige works part-time but trains for a college scholarship. Nick left in March. Polly sold her wedding rings for $8,000. Polly may be able to claim dependency exemptions for Paige and Maude depending on whether they meet the tests for qualifying child, qualifying relative, gross income, support and other rules. Polly should review her tax situation considering these dependency exemption rules.
2. The Big Picture (slide 1 of 2)
• Polly maintains a household in which she lives with her
– Unemployed husband (Nick),
– Stepdaughter (Paige), and
– A family friend (Maude).
• She provides more > ½ the support of both Paige and Maude.
– Maude was fatally injured in an automobile accident in February
• Polly paid for her hospitalization and funeral expenses.
– Paige, an accomplished gymnast, graduated from high school last year.
• Paige has a part-time job but spends most of her time training and looking
for an athletic scholarship to the ‘‘right’’ college.
2
3. The Big Picture (slide 2 of 2)
• In March, Nick left for parts unknown and has not
been seen or heard from since.
• Polly sold her wedding rings to a cousin who was
getting married.
– The rings cost $15,000.
– The rings were sold for their approximate value of $8,000.
• Based on these facts, what are Polly’s income tax
concerns for the current year?
– Read the chapter and formulate your response.
3
5. Income -Broadly Conceived
• Includes all the taxpayer’s income, both
taxable and nontaxable
– Essentially equivalent to gross receipts
• It does not include a return of capital or receipt of
borrowed funds
5
6. Partial List of Exclusions
from Gross Income
• Accident insurance proceeds • Meals and lodging (if furnished for
• Annuities (cost element) employer’s convenience)
• Bequests • Military allowances
• Child support payments • Minister’s dwelling rental value
• Cost-of-living allowance (for allowance
military) • Railroad retirement benefits (to a
• Damages for personal injury or limited extent)
sickness • Scholarship grants (to a limited
• Gifts received extent)
• • Social Security benefits (to a limited
Group term life insurance, premium extent)
paid by employer (for coverage up to
$50,000) • Unemployment compensation (to a
• Inheritances limited extent)
• Veterans’ benefits
• Interest from state and local (i.e.,
municipal) bonds • Welfare payments
• Life insurance paid on death • Workers’ compensation benefits
Exhibit 3-1
6
7. Gross Income
• The Internal Revenue Code defines gross
income broadly as ‘‘except as otherwise
provided . . . , all income from whatever
source derived’’
• Gross income does not include unrealized
gains
7
8. Partial List of Gross Income Items
(slide 1 of 2)
• Alimony • Dividends
• Annuities (income element) • Embezzled funds
• Awards • Employee awards (in certain
• Back pay cases)
• Bargain purchase from employer • Employee benefits (except certain
• fringe benefits)
Bonuses
• Estate and trust income
• Breach of contract damages
• Farm income
• Business income
• Fees
• Clergy fees
• • Gains from illegal activities
Commissions
• Gains from sale of property
• Compensation for services
• Gambling winnings
• Death benefits
• Group term life insurance,
• Debts forgiven premium paid by employer (for
• Director’s fees coverage over $50,000)
Exhibit 3.2
8
9. Partial List of Gross Income Items
(slide 2 of 2)
• Hobby income • Rents
• Interest • Rewards
• Jury duty fees • Royalties
• Living quarters, meals (unless • Salaries
furnished for employer’s • Severance pay
convenience) • Strike and lockout benefits
• Mileage allowance • Supplemental unemployment
• Military pay (unless combat pay) benefits
• Notary fees • Tips and gratuities
• Partnership income • Travel allowance (in certain
• Pensions cases)
• Prizes • Treasure trove (found property)
• Professional fees • Wages
• Punitive damages
Exhibit 3.2
9
10. Deductions - Individual Taxpayers
• Individual taxpayers have two categories of
deductions:
– Deductions for adjusted gross income (AGI)
– Deductions from adjusted gross income
10
11. Deductions For AGI (slide 1 of 2)
• Sometimes known as above-the-line
deductions
– On the tax return, they are taken before the ‘‘line’’
designating AGI
11
12. Deductions For AGI (slide 2 of 2)
• Deductions for AGI include:
– Ordinary and necessary expenses incurred in a trade or
business
– One-half of self-employment tax paid
– Alimony paid
– Certain payments to an IRA and Health Savings Accounts
– Unreimbursed moving expenses
– Fees for college tuition and related expenses
– Interest on student loans
– The capital loss deduction, and
– Others
12
13. Adjusted Gross Income (AGI)
• AGI is an important subtotal
– Serves as the basis for computing percentage
limitations on certain itemized deductions such as
• Medical expenses
• Charitable contributions
• Certain casualty losses
– e.g., Medical expenses are deductible only to the
extent they exceed 7.5% of AGI
• This limitation might be described as a 7.5% “floor”
under the medical expense deduction
13
14. Deductions From AGI (slide 1 of 3)
• Deductions from AGI include:
– The greater of:
• Itemized deductions, or
• The standard deduction
– Personal and dependency exemptions
14
15. Deductions From AGI (slide 2 of 3)
• A partial list of itemized deductions includes:
– Medical expenses (in excess of 7.5% of AGI)
– Certain taxes and interest
– Charitable contributions
– Casualty Losses (in excess of 10% of AGI)
– Deductions for expenses related to
• The production or collection of income, and
• The management of property held for the production of income
– Certain miscellaneous itemized deductions (in excess of
2% of AGI)
15
16. Deductions From AGI (slide 3 of 3)
• The standard deduction is the sum of two
components:
– Basic standard deduction
• Amount allowed is based on taxpayer’s filing status
– Additional standard deductions
• Available for taxpayers who are
– Age 65 or over, and/or
– Blind
• Two additional standard deductions are allowed for a taxpayer who
is age 65 or over and blind
• Amount allowed depends on filing status
16
17. Standard Deduction (slide 1 of 2)
• The basic standard deduction (BSD) amount
depends on filing status of taxpayer
Filing status 2011 2012
Single $5,800 $5,950
MFJ, SS 11,600 11,900
HH 8,500 8,700
MFS 5,800 5,950
TABLE 3.1
17
18. Standard Deduction (slide 2 of 2)
• Additional standard deduction (ASD)
– For taxpayers age 65 or older and/or legally blind
Filing Status 2011 2012
Single $1,450 $1,450
MFJ, SS 1,150 1,150
HH 1,450 1,450
MFS 1,150 1,150
TABLE 3.2
18
19. Determining Standard Deduction
• Examples (2012 tax year):
– Taxpayer is single, blind, and age 65 or older
• SD = $5,950 (BSD) + $1,450 (ASD) + $1,450 (ASD) =
$8,850
– Taxpayers are married, filing jointly, one blind,
and both age 65 or older
• SD = $11,900 (BSD) + $1,150 (ASD) + $1,150 (ASD)
+ $1,150 (ASD) = $15,350
19
20. Taxpayers Ineligible For Standard
Deduction
• Certain taxpayers cannot use the SD:
– Married, filing separately, when either spouse
itemizes deductions
– Nonresident aliens
– Individual filing return for tax year of less than 12
months because of change in annual accounting
period
20
21. SD Limit For Person
Claimed as Dependent
• Individual claimed as dependent has a BSD in
2012 limited to the greater of:
– $950 or
– $300 plus earned income (but not exceeding
normal BSD)
• ASD amount(s) still available
21
22. Examples of SD Limit (slide 1 of 2)
• Dependent’s SD (2012 tax year):
– A blind child who earns $200 and is claimed by
parents as a dependency exemption
• SD = $950 (BSD) + $1,450 (ASD) = $2,400
– A child who earns $1,500 and is claimed by
parents as a dependency exemption
• SD = $1,800 [BSD equal to greater of $950 or ($300 +
$1,500 earned income)]
22
23. Examples of SD Limit (slide 2 of 2)
• Examples of dependent’s SD (2012 tax year)
– A child who earns $6,000 and is claimed by
parents as a dependency exemption
• SD = $5,950 [BSD limited to normal amount]
23
24. Personal and Dependency
Exemption Amounts
• Amounts
– 2011: $3,700 per exemption
– 2012: $3,800 per exemption
• Personal and dependency exemptions
– One per taxpayer (two personal exemptions when
married, filing jointly) and for each dependent
• Exception: Individual claimed as dependent by another
taxpayer does not receive a personal exemption
24
25. Personal and Dependency
Exemptions In Year Of Death
• Personal exemption allowed on joint return for
spouse who dies during the year
– Example: Tom and Betty were married in 1990.
Tom dies on February 1, 2012. A personal
exemption may be claimed for Tom on the
taxpayers’ 2012 joint return.
25
26. Dependency Exemptions (slide 1 of 2)
• A dependency exemption is available for one
who is either a qualifying child or a qualifying
relative
– A qualifying child must meet the following tests:
• Relationship
• Abode
• Age, and
• Support
26
27. Dependency Exemptions (slide 2 of 2)
• Congress has tried to establish a uniform
definition of qualifying child for purposes of
the:
– Dependency exemption
– Head-of-household filing status
– Earned income tax credit
– Child tax credit
– Credit for child and dependent care expenses
27
28. Relationship Test
• The child must be the taxpayer’s:
– Son or daughter
– Stepson or stepdaughter
– Brother or sister
– Stepbrother or stepsister
– Half brother or half sister, or
– A descendant of such individual (e.g., grandchildren,
nephews, nieces)
• A child who has been adopted, or whose adoption is
pending, qualifies
• A foster child may also qualify
28
29. Abode Test
• A qualifying child must live with the taxpayer
for more than half of the year
– Temporary absences from the household due to
special circumstances (e.g., illness, education) are
not considered
29
30. Age Test
• The child must be under age 19 or under age
24 in the case of a student
– A student is a child who, during any part of five
months of the year, is enrolled full time at a school
or government-sponsored on-farm training course
– Individuals who are disabled are not subject to the
age test
30
31. The Big Picture - Example 14
Dependency Exemptions
• Return to the facts of The Big Picture on p. 3-1.
• Does Paige meet the requirements of a qualifying
child so Polly can claim a dependency exemption for
her?
– Paige satisfies the relationship and abode tests, but the
answer to the age test remains unclear.
– Since she is not a full-time student or disabled, she must be
under 19 to meet the age test.
• Unfortunately, the facts given do not provide Paige’s precise age.
31
32. Support
• To be a qualifying child, the individual must
not be self-supporting
– Cannot provide more than one-half of his or her
own support
– In the case of a full-time student, scholarships are
not considered to be support
32
33. Tiebreaker Rules
• In situations where a child may be a qualifying
child for more than one person
– Tiebreaker rules specify which person has priority
in claiming the dependency exemption
Table 3.3
33
34. Qualifying Relative
• In order to claim a dependency exemption for
a qualifying relative, the following tests must
be met:
– Relationship
– Gross income
– Support
34
35. Relationship Test
• The relationship test for a qualifying relative is
more expansive than for a qualifying child.
Also included are the following relatives:
– Lineal ascendants (e.g., parents, grandparents)
– Collateral ascendants (e.g., uncles, aunts)
– Certain in-laws (e.g., son-, daughter-, father-,
mother-, brother-, and sister-in-law)
• The relationship test also includes unrelated
parties who live with the taxpayer
35
36. The Big Picture - Example 19
Dependency Exemptions
• Return to the facts of The Big Picture on p. 3-1.
• Is Maude a qualifying relative?
– Although Maude is unrelated to Polly, she qualifies as
Polly’s dependent by being a member of the household.
– Since Maude is a dependent, Polly can also claim the
medical expenses she paid on Maude’s behalf.
• The funeral expenses are not deductible.
• Although Maude lived for only two months, the full amount of the
dependency exemption is allowed and does not have to be
apportioned.
36
37. Gross Income Test
• Dependent’s gross income must be less than
the exemption amount ($3,800 for 2012)
37
38. The Big Picture - Example 22
Dependency Exemptions
• Return to the facts of The Big Picture on p. 3-1.
• Assuming that Paige is not a qualifying child, can she
be a qualifying relative for dependency exemption
purposes?
– She meets the relationship and support tests, but what
about the gross income test?
– If her income from her part-time job is less than $3,800,
she does qualify and can be claimed by Polly as a
dependent.
38
39. Support Test
• Taxpayer must provide more than 50% of the
qualifying relative’s support
– Only amounts expended are considered in the
support test
– Scholarships are not considered in the support test
• Two exceptions to the support test:
– Multiple support agreements
– Children of divorced parents
39
40. Multiple Support Agreements
• Allows one member of a group providing >
50% of support to claim individual even
though no one person provides > 50% support
– Eligible parties must provide > 10% of support
– Each eligible party must meet all other dependency
requirements
• Example - Allows children of elderly parent to
claim exemption for parent when none
individually meets the 50% support test
40
41. Children of Divorced Parents
• Special rules apply if the parents meet the following
conditions:
– They would have been entitled to the dependency exemption had they
been married and filed a joint return
– They have custody (either jointly or singly) of the child for more than
half of the year
• Under the general rule, the parent having custody of the child
for the greater part of the year (i.e., the custodial parent) is
entitled to the dependency exemption
– General rule does not apply if
• A multiple support agreement is in effect
• Custodial parent issues a waiver in favor of the noncustodial parent
41
42. Other Rules for
Dependency Exemptions
• In addition to fitting into either the qualifying
child or the qualifying relative category, a
dependent must also meet:
– The joint return, and
– The citizenship or residency tests
42
43. Joint Return Test
• Dependent cannot file a joint return with
spouse unless:
– Filing solely for refund of tax withheld
– No tax liability exists for either spouse
– Neither spouse required to file return
43
44. Citizenship or Residency Test
• Dependent must be a U.S. citizen or a resident
of U.S., Canada, or Mexico for some part of
the calendar year in which the taxpayer’s tax
year begins
– An exception provides that an adopted child need
not be a citizen or resident of the U.S. (or a
contiguous country) as long as his or her principal
abode is with a U.S. citizen
44
45. Child Tax Credit
• $1,000 tax credit is allowed for each
dependent child under the age of 17
– Qualifying child includes stepchildren and eligible
foster children
45
46. Filing Requirements (slide 1 of 2)
• General Rule: Tax return must be filed if gross
income is ≥ the sum of the standard deduction
and exemption amount
• ASD for blind does not apply for this determination
– Special rules apply for dependents and self-
employed taxpayers
46
47. Filing Requirements (slide 2 of 2)
• Tax return of an individual is due on or before
the 15th day of the 4th month after taxpayer’s
year end
– Most individuals are calendar year taxpayers, thus,
due date is April 15
• May obtain a 6 month extension of time to file
– Excuses a taxpayer from penalty for failure to file,
not from penalty for failure to pay
• If more tax is owed, extension request (Form 4868)
should be accompanied by check for balance of tax due
47
48. Filing Status
• There are 5 filing statuses
– Single
– Married, filing jointly
– Surviving spouse (qualifying widow or widower)
– Head of household
– Married, filing separately
• Filing status affects tax rate brackets, standard
deduction, and other amounts
48
49. Single Filing Status
• Includes a taxpayer who is unmarried or
separated from spouse by a divorce decree or
separate maintenance agreement and does not
qualify for another filing status
– Marital status is determined as of the last day of
the tax year
• When a spouse dies during the year, marital status is
determined as of the date of death
49
50. Married Filing Jointly
(MFJ) Filing Status
• Married as of last day of taxable year, or
• Spouse dies during taxable year
50
51. Surviving Spouse Filing Status
• Same tax rate brackets as married, filing jointly
• File as surviving spouse for 2 years after death of
spouse if taxpayer maintains a home in which a
dependent child lives
– For the year of death, surviving spouse is treated as being
married
• Thus, a joint return can be filed if the deceased spouse’s executor
agrees
51
52. Married Filing Separately Filing Status
• Married but not filing a return with spouse and
not abandoned spouse
52
53. Head of Household (HH) Filing Status
• Must be unmarried as of end of year or an
abandoned spouse
• Must pay > half the cost of maintaining a
household which is the principal home of a
dependent for more than half of tax year
– A dependent must satisfy either the qualifying
child or the qualifying relative category
• A qualifying relative must also meet the relationship
test
53
54. The Big Picture - Example 32
Head-of-Household Filing Status
• Return to the facts of The Big Picture on p. 3-1.
• Assuming that Polly can be treated as single
(i.e., not married), can Maude qualify Polly for
head-of-household filing status?
– The answer is no.
– Even though Maude can be claimed as Polly’s
dependent, she does not meet the relationship test.
54
55. Exception to the HH Requirements
• HH may be claimed if taxpayer maintains a
separate home for his or her parents
– At least one parent must qualify as a dependent
55
56. Abandoned Spouse
• Allows married taxpayer to file as Head of
Household if taxpayer:
– Does not file a joint return
– Paid > half the cost of maintaining a home
– Spouse did not live in home during last 6 months
of tax year
– Home was principal residence of taxpayer’s child
for > half of year
– Can claim child as a dependent
56
57. The Big Picture - Example 35
Abandoned Spouse Filing Status
• Return to the facts of The Big Picture on p. 3-1.
• Can Polly qualify as an abandoned spouse?
– Yes, if she can claim Paige as a dependent—either
as a qualifying child or as a qualifying relative.
– If so, Polly can use head-of-household filing
status.
– If not, her filing status is married person filing
separately.
57
58. Taxes Rates
• Tax liability is computed using either the Tax Table
method or the Tax Rate Schedule method
– Most taxpayers must use the Tax Tables
– Certain taxpayers may not use the Tax Table method
including:
• An individual who files a short period return
• Individuals whose taxable income exceeds the maximum (ceiling)
amount in the Tax Table
– The 2011 Tax Table applies to taxable income below $100,000
• An estate or trust
• For 2011 and 2012 the tax rates are 10%, 15%, 25%,
28%, 33%, and 35%
58
59. Kiddie Tax (slide 1 of 4)
• Net unearned income (NUI) of child is taxed at
parents’ rate
– Child must be under age 19 at end of year (or
under age 24 if a full-time student)
– NUI generally equals unearned income less $1,900
(2012 tax year)
59
60. Kiddie Tax (slide 2 of 4)
• Unearned income includes:
– Taxable interest
– Dividends
– Capital gains
– Rents
– Royalties
– Pension and annuity income, and
– Unearned income from trusts
60
61. Kiddie Tax (slide 3 of 4)
• Computing NUI for Kiddie Tax for 2012:
– Unearned income
– Less: $950
– Less: The greater of:
i) $950, or
ii) Allowable itemized deductions connected
with production of unearned income
– Equals: net unearned income
61
62. Kiddie Tax (slide 4 of 4)
• Net unearned income taxed at parents’ rate
– Remainder of taxable income taxed at child’s rate
• Two options for computing the tax
– A separate return may be filed for the child
• The tax on net unearned income (referred to as the allocable
parental tax) is computed as though the income had been included
on the parents’ return
– Form 8615 is used to compute the tax
– The parents may elect to report child’s income on their
own return
• Certain requirements must be met
62
63. Gains and Losses from Property
Transactions (slide 1 of 3)
• In order for gains (losses) to be recognized
(included in gross income), they must be
realized:
– Realized gain (loss) = amount realized - adjusted
basis
• Amount realized = selling price - costs of disposition
• Adjusted basis = cost + capital additions - cost recovery
63
64. Gains and Losses from Property
Transactions (slide 2 of 3)
• All realized gains are recognized unless a
specific tax provision provides otherwise (e.g.,
nontaxable exchanges)
• Realized losses may or may not be recognized
depending on the circumstances
– Generally, losses on the sale or disposition of
personal use property are not recognized
64
65. Gains and Losses from Property
Transactions (slide 3 of 3)
• Once recognized gains or losses have been
determined, they must be classified as
ordinary or capital
– Ordinary gains are fully taxable
– Ordinary losses are fully deductible
• Capital gains and losses are subject to special
tax treatment
65
66. Gains and Losses from Capital Asset
Transactions (slide 1 of 2)
• Capital assets are defined as any property
other than:
– Inventory,
– Accounts Receivable, and
– Depreciable property or real property used in a
business
• Most personal use assets owned by individuals
are capital assets
– Losses on these assets are not deductible
66
67. Gains and Losses from Capital Asset
Transactions (slide 2 of 2)
• Gains and losses from capital asset
transactions must be netted
– Net gains and losses by holding period
– If excess losses result, they are shifted to the
category carrying the highest tax rate
67
68. Max Tax Rates for Net
Capital Gains of Individuals
Classification Maximum Rate
Short-term gains (held ≤ one year) 35%
Long-term gains (held > one year)
• Collectibles 28%
• Certain depreciable property
used in a trade or business
(unrecaptured § 1250 gain) 25%
• All other long-term capital gains 15%, 5%,
or 0%
68
69. Treatment of Capital Losses
• Net capital losses of individuals are deductible
for AGI up to $3,000 yearly
– Excess capital losses are carried over to the next
tax year
– When carried over, capital losses retain their
classification as short- or long-term
69
70. The Big Picture - Example 48
Treatment Of Net Capital Loss
• Return to the facts of The Big Picture on p. 3-1.
• Polly’s sale of her wedding rings resulted in a
realized capital loss of $7,000
– [$8,000 (selling price) - $15,000(cost basis)].
• Because they were personal use property,
Polly cannot deduct the loss.
70
71. Refocus On The Big Picture (slide 1 of 4)
• Polly’s major concern is her filing status.
– If she qualifies as an abandoned spouse, she is
entitled to file as head of household.
• If not, she is considered to be a married person filing
separately.
– In order to be an abandoned spouse, Polly must be
able to claim Paige as a dependent.
71
72. Refocus On The Big Picture (slide 2 of 4)
• To be a dependent, Paige must meet the requirements
of a qualifying child or a qualifying relative.
– For qualifying child purposes, Paige must meet either
• The age test (i.e., under age 19), or
• The full-time student (under age 24) test.
– Paige is not a full-time student - is she under age 19?
– If so, she is a qualifying child.
– If Paige is not a qualifying child, is she a qualifying
relative?
– Here, the answer depends on meeting the gross income test.
– How much did Paige earn from her part-time job?
» If her earnings are under $3,800, she satisfies the gross income
test.
72
73. Refocus On The Big Picture (slide 3 of 4)
• If Paige can be claimed as a dependent, Polly is an
abandoned spouse entitled to head-of-household
filing status.
– If not, she is a married person filing separately.
• Maude can be claimed as Polly’s dependent because
she is a member of the household.
– It does not matter that she died in February
• The dependency exemption amount need not be apportioned and is
allowed in full.
– Because Maude is her dependent, Polly can claim the
medical expenses she paid on Maude’s behalf.
• The funeral expenses, however, are not deductible.
73
74. Refocus On The Big Picture (slide 4 of 4)
• Does Maude qualify Polly for head-of-
household filing status?
– No—although she is a dependent, Maude does not
meet the relationship test.
• The sale of the wedding rings results in a
capital loss of $7,000($8,000 – $15,000).
– Because the loss is for personal use property, it
cannot be claimed for tax purposes.
74
