OVERVIEW OF THE TAX STRUCTURE

Transcription

1 Chapter 1 OVERVIEW OF THE TAX STRUCTURE CHAPTER CONTENTS INCOME TAX OBJECTIVES 101 BASIC TAX FORMULA 102 INDIVIDUAL TAXPAYERS 103 GROSS INCOME 104 DEDUCTIONS AVAILABLE TO INDIVIDUAL TAXPAYERS 105 STANDARD DEDUCTION 106 EXEMPTIONS 107 DEPENDENCY EXEMPTION REQUIREMENTS 108 QUALIFYING CHILD 109 QUALIFYING RELATIVES 110 QUALIFYING NONRELATIVES 111 TAX BASE FORMULA ANOTHER VIEW 112 FILING STATUS 113 FILING REQUIREMENTS FOR INDIVIDUALS 114 TAX YEAR 115 TAXPAYER RESPONSIBILITIES 116 PROPERTY DISPOSALS 117 REDUCING THE TAX BITE 118

2 1 2 Essentials of Federal Income Taxation LEARNING OBJECTIVES After completing Chapter 1, you should be able to: 1. Describe the various components of the taxable income formula. 2. Distinguish between the concepts of gross income, deductions, and tax credits. 3. Compute a taxpayer s total standard deduction. 4. Compute the number and amount of a taxpayer s personal and dependency exemptions. 5. Determine the taxpayer s filing status. 6. Understand a taxpayer s filing requirements and taxpayer responsibilities. 7. Understand how Congress uses the tax laws to attain certain objectives and how taxpayers can use tax planning to their advantage. CHAPTER OVERVIEW The Sixteenth Amendment to the Constitution gives Congress the power to levy and collect income taxes. After its ratification, Congress enacted the Revenue Act. For individual taxpayers, the Act taxed income at a 1% rate. When income reached $20,000, an additional surtax was imposed. This surtax started at 1% and gradually increased to 6% for taxable income above $500,000. The government continues to use a progressive tax rate structure. This means that as income rises, the tax rate increases. In 2009, tax rates range from 10% to 35%. The current rate schedules appear on the Handy Tax Facts page on the inside front cover of this book. Our current tax system, like the original one, requires taxpayers to determine their own taxes. It also requires each taxpayer to file a tax return and pay any tax due the government by certain deadlines. Taxpayers that fail to meet these requirements face possible fines, penalties, and imprisonment. In addition, the Internal Revenue Service (IRS) charges interest on unpaid taxes. Many taxpayers seek help from tax professionals, who prepare about half of all filed tax returns. Although many taxpayers use paid professionals, every taxpayer should have a basic understanding of the tax laws. This understanding will help them prepare their own returns or identify facts needed by a preparer. It also will help them review a professionally prepared return before filing it. Understanding the tax laws can help in recognizing potential problems before taxable events take place. Through proper planning, taxpayers can reduce the tax bite. The first part of this chapter provides an overview of our current income tax system. The latter part presents basic tax planning principles.

3 101 INCOME TAX OBJECTIVES Overview of the Tax Structure 1 3 The federal income tax system raises money to help cover the government s annual operating costs. However, Congress also uses tax laws to achieve various economic, political, and social goals. These include redistributing the country s wealth, as well as encouraging economic growth, full employment, and certain behaviors. For example, if the goal is to increase employment, Congress can lower taxes, which gives taxpayers more money to spend. This, in turn, creates more demand for products and services. The end result is a need for an increased number of workers to make the products and provide the services. An example of Congress s use of the tax laws to encourage certain behavior involves tax breaks to those who buy hybrid cars. Hybrid cars are more fuel-efficient and emit fewer pollutants than standard cars. However, they cost several thousand dollars more than their non-hybrid counterparts. Even with higher gas prices, the higher price of hybrid cars has kept many consumers from buying them. Offering increased tax breaks to those that buy hybrid cars was introduced in 2006 to encourage consumers to buy them over standard models. If these tax breaks work, the desired result will be a decrease in U.S. demand for gasoline and an overall improvement in air quality. 102 BASIC TAX FORMULA Governments levy taxes by assessing a tax rate to a tax base. In the income tax system, the tax base is taxable income. Simply put, taxable income is the difference between the amounts of income the government decides to tax and deductions it allows against this income. Anything that causes wealth to increase generally is regarded as income. However, not all items that increase one s wealth are taxed. Income that the government taxes is called gross income. Most deductions involve expenses that the government allows to reduce gross income. However, some deductions are not tied to expenditures. Gross income is the subject of Chapters 3 and 4. Tax deductions are discussed later in the chapter and are also the focus of Chapters 5 and 6. Basic Taxable Income Formula Income from all sources Exempt income = Gross income Deductions = Taxable income For purposes of this textbook a taxpayer is any person or entity required to file an income tax return with the Internal Revenue Service (IRS). Although this term suggests that taxes are being paid, not all taxpayers pay income taxes. Flow-through entities report their gross income and tax deductions to the IRS. However, it is the owners of these entities that pay taxes on their respective shares of the entity s taxable income. Partnerships and S corporations are examples of flow-through entities. They are the focus of Chapter 15. Regular corporations (called C corporations ) are business entities that pay tax each year on their taxable income. In this regard, they are similar to individual taxpayers. Although the focus of this textbook begins with the individual taxpayer, the taxation of businesses is presented in the book as well. Many of the tax laws described in this textbook apply equally to all types of taxpayers. However, special rules sometimes apply only to one group of taxpayers. For example, the basic formula for computing taxable income presented above is the same for both corporations and individuals. However, individuals are entitled 102

4 1 4 Essentials of Federal Income Taxation to more types of deductions and thus use an expanded taxable income formula (described in 103). For purposes of this textbook, unless from the discussion it is clear that use of the term taxpayer refers to a particular type of taxpayer (for example, an individual or a corporation), when the term taxpayer is used when discussing a tax law, such law applies to all types of taxpayers, including corporations, individuals, and flow-through entities. If a tax law is unique to one type of taxpayer, then the title of the section or the discussion itself will state the type of taxpayer to which the law applies. After C corporations and individuals compute taxable income, they compute their tax liability using the tax rates set by Congress. Although different tax rates may apply, the federal income tax rates are progressive, which means that as taxable income increases, so too does the tax rate. These taxpayers may owe other taxes in addition to the income taxes. Individuals may owe self-employment taxes, penalties for early distributions from retirement accounts, or alternative minimum tax (AMT). Corporations also may be subject to AMT. Individuals and C corporations may also be entitled to subtract tax credits from these taxes to arrive at their taxes owed (or refund due) at the end of the year. Tax credits can be business-related or personal in nature. The former applies to all types of businesses. The latter applies only to individual taxpayers. Tax credits generated by flow-through entities are passed through to the owners, who then report the tax credits on their income tax returns. Calculation Of Taxes Owed (To Be Refunded) Taxable income Tax rate = Income tax liability + Additional taxes Tax credits = Final tax due (refund) Deductions Versus Credits The distinction between a deduction and a credit is important. Tax credits reduce tax liability. Tax deductions reduce taxable income. Tax credits reduce the taxpayer s taxes by the amount of the tax credit. Deductions reduce the taxpayer s taxes by the amount of the deduction times the taxpayer s tax rate. For example, a $100 deduction saves the taxpayer $15 if the tax rate is 15% ($100 15%), but saves him $35 if the tax rate is 35% ($100 35%). A $100 tax credit, on the other hand, reduces taxes by $100 regardless of the taxpayer's tax rate. 103 INDIVIDUAL TAXPAYERS Although there are a variety of types of income, the concept of gross income is the same for all taxpayers. That is, there is some income that the government taxes, while other types of income are not subject to income tax. The tax laws also allow a variety of deductions in the calculation of taxable income. Individual taxpayers can reduce their taxable income by a mix of business and personal deductions. Accordingly, the tax laws separate the deductions available to individuals into two categories: deductions for adjusted gross income (AGI) and deductions from AGI. The latter are deductions that are more personal in nature. Deductions from AGI are introduced in this chapter and are the focus of Chapters 5 and

5 Overview of the Tax Structure 1 5 Basic Tax Formula for Individuals Income from all sources Exempt income = Gross income Deductions for AGI (adjusted gross income) = AGI Deductions from AGI Itemized deductions or standard deduction Exemptions (personal and dependency) = Taxable income Tax rate = Income tax liability + Additional taxes Tax credits = Final tax due (refund) The tax rate that individual taxpayers apply to taxable income depends on their filing status. A person s filing status depends on whether he or she is married on the last day of the tax year, along with other factors. More about the rules for each filing status will be presented later in the chapter. There are five filing statuses: 1. Married filing jointly (MFJ) 2. Married filing separately (MFS) 3. Head of household (HOH) 4. Single 5. Surviving spouse (SS) Individuals who are required to file an income tax return file one of the following tax returns: 1. Form 1040EZ, Income Tax Return for Single and Joint Filers with No Dependents 2. Form 1040A, U.S. Individual Income Tax Return 3. Form 1040, U.S. Individual Income Tax Return As its title suggests, Form 1040EZ is the easiest of the tax forms to complete. However, only certain taxpayers can use Form 1040EZ, as will be explained in Chapter 2. Form 1040A is introduced in Chapters 2 and 4. Although many individual taxpayers can use either Form 1040EZ or 1040A, many must file Form 1040 (often referred to as the long form ). 104 GROSS INCOME Taxpayers must be able to determine their gross income. The Internal Revenue Code (the Code) defines gross income as all wealth that flows to a taxpayer from whatever source derived. It then exempts some income from taxation. The Code lists the following different gross income sources (and implies that others exist): 1. Compensation for services, including salary, wages, fees, commissions, fringe benefits, etc. 2. Gross income from business 3. Gains from the disposal of property 4. Interest 5. Rents 6. Royalties 104

6 1 6 Essentials of Federal Income Taxation 7. Dividends 8. Alimony and separate maintenance payments 9. Annuities 10. Income from life insurance proceeds 11. Pensions 12. Income from forgiven debt 13. Share of distributive partnership income and prorata share of S Corporation income 14. Income in respect of a decedent 15. Income from an interest in an estate or trust To determine gross income, taxpayers generally examine their various sources of income (items that increase their wealth) and sort out taxable income from exempt income. Regardless of the form or name of an income item, proper authority must exist to exclude the item from gross income. Taxpayers may find such authority in the tax laws, which include the Code, Treasury Regulations, IRS rulings, or case law. From gross income, taxpayers subtract allowed deductions to arrive at taxable income Importance of Gross Income It is important that taxpayers correctly compute their gross income. When gross income exceeds a certain amount, taxpayers must file an income tax return. Failure to file a proper return on time can result in tax penalties. Also, when a taxpayer accidentally understates gross income by more than 25%, the law extends the time the IRS has to audit the taxpayer s return. Finally, individuals may be allowed or denied a dependency exemption deduction for another person depending on the amount of that person s gross income. 105 DEDUCTIONS AVAILABLE TO INDIVIDUAL TAXPAYERS Individual taxpayers have two broad groups of deductions. They subtract one group from gross income to arrive at AGI. They subtract the other group from AGI to arrive at taxable income. Some call them for or from deductions. Others call them above-the-line or below-theline deductions. Taxpayers subtract above-the-line deductions from gross income to arrive at AGI. They subtract below-the-line deductions from AGI to arrive at taxable income. There are two types of below-the-line deductions. One is the greater of a taxpayer s itemized deductions or standard deduction. The other is exemptions (personal and dependency). The Code limits the amount of exemptions and itemized deductions that a taxpayer may claim. AGI generally serves as a basis for determining these limitations. Corporations, partnerships, estates, and trusts do not compute AGI Deductions for AGI The Code defines an individual s AGI as gross income less certain deductions. Some of the major deductions include: 1. Trade and business deductions for business owners 2. Losses on the disposal of business or investment property (subject to limitations) 3. Deductions related to rental and royalty income 4. Certain contributions to retirement plans of self-employed individuals 5. Certain contributions to traditional Individual Retirement Accounts (IRAs) 6. Penalties for early withdrawals from certificates of deposits

7 Overview of the Tax Structure Alimony paid 8. Qualified moving expenses 9. One-half of self-employment tax 10. Health insurance premiums paid by self-employed persons 11. Individual contributions to a medical savings or health savings account 12. Interest paid on student loans 13. Educator's expenses 14. Tuition and fees deduction 15. Domestic production activities deduction Deductions from AGI After computing AGI, individuals reduce AGI by either itemized deductions or a standard deduction. They also reduce it by personal and dependency exemptions. The next few sections present the standard deduction and exemptions. Itemized deductions fall into seven groups. 1. Medical expenses 2. Taxes 3. Interest 4. Charitable contributions 5. Casualty and theft losses 6. Job expenses and some miscellaneous deductions 7. Other miscellaneous deductions 106 STANDARD DEDUCTION The standard deduction is a deduction from AGI that only applies to individual taxpayers. It consists of two amounts: the basic standard deduction and the additional standard deduction. Both amounts are adjusted for inflation each year. Taxpayers normally use the standard deduction when it exceeds their total itemized deductions. Taxpayers filing Form 1040EZ or Form 1040A must use the standard deduction. Also, when spouses file separate returns, both spouses must either itemize deductions or take the standard deduction. Thus, if one spouse itemizes, the other spouse s standard deduction is zero. This forces the other spouse to itemize as well. Although taxpayers may deduct certain personal expenses as itemized deductions, about 70% use the standard deduction. For most taxpayers, this constitutes one of the two major deductions on the tax return. The other is the exemption amount. An employed person who does not pay alimony or contribute to an individual retirement account usually has little, if anything, else to deduct against gross income. This makes computing taxable income fairly easy for most Americans. They simply add up their gross income from various sources and deduct the standard deduction and the exemption amounts to arrive at taxable income Basic Standard Deduction There are four basic standard deduction amounts. Filing status usually determines which amount applies. Although most individuals can deduct the basic standard deduction amount, some cannot. A special rule applies to persons who are claimed as a dependent of another taxpayer, as will be explained later (see , Standard Deduction for Dependents)

8 1 8 Essentials of Federal Income Taxation Basic Standard Deduction for 2009 Filing Status Amount Married filing jointly $11,400 Surviving spouse 11,400 Head of household 8,350 Single 5,700 Married filing separately 5, Additional Standard Deduction Blind and elderly taxpayers claim an additional standard deduction. Taxpayers become elderly when they reach age 65. This additional deduction is available only for the taxpayer, which includes both spouses when a joint return is filed. A taxpayer cannot claim an additional standard deduction for an elderly or blind dependent. The additional standard deduction increases only the basic standard deduction; it never increases the taxpayer s itemized deductions. There are two additional standard deduction amounts. The taxpayer s filing status determines which one is used. Additional Standard Deduction for 2009 MFJ, MFS and surviving spouse $1,100 Single and head of household 1,400 Each incidence of age and blindness carries with it an additional deduction. In the case of married taxpayers, each spouse is eligible for both deductions. Thus, if both spouses are age 65, the total additional standard deduction is $2,200 (2 $1,100). If both spouses are age 65 and one is blind, the extra deduction is $3,300 (3 $1,100). For a single person, age 65 and blind, the extra deduction is $2,800 (2 $1,400). For a taxpayer to get an additional standard deduction, his or her status as elderly or blind must exist at the end of the tax year (or at death). For tax purposes, individuals age the day before their calendar birthday. Thus, a taxpayer who turns 65 on January 1 is 65 for tax purposes as of December 31 of the preceding year. A taxpayer may claim the additional deduction for blindness either by failing a visual ability or field of vision test. For the visual ability test, sight in either eye cannot exceed 20/200 with a corrective lens. For the field of vision test, the person s field of vision cannot exceed 20 degrees. The taxpayer supports a blindness claim with a certified statement from an eye doctor. Example 1 Pam Starkey is 70 and blind. Her filing status is single. Starkey s 2009 total standard deduction equals $8,500 ($5,700 + ($1,400 2)). Example 2 Don and Nancy Miner are married and file a joint return (MFJ) in As of December 31, 2009, Don is 67 and Nancy is 64. Neither have any problems with their vision. The Miners add to their $11,400 basic standard deduction for MFJ an additional $1,100 for Don s age. Their total standard deduction for 2009 equals $12,500. If the Miners itemized deductions exceed this amount, they will itemize. Otherwise they will subtract $12,500 from their AGI when computing their taxable income for

9 Overview of the Tax Structure 1 9 In 2009, taxpayers who do not itemize deductions can add to their standard deduction up to $500 ($1,000 on a MFJ return) of the real estate taxes they pay on their principal residence. They also can deduct state and local sales taxes on up to $49,500 paid for a new qualified motor vehicle purchased between February 17, 2009 and December 31, The sales tax deduction is completely phased out for taxpayers with modified AGI over $135,000 ($260,000 on a MFJ return). A partial deduction is available for taxpayers with modified AGI between $125,000 and $135,000 ($250,000 $260,000 for MFJ). Modified AGI is defined as AGI plus any foreign earned income exclusion (discussed at ). These additional amounts are in addition to any additional standard deduction amounts for age and/or blindness. Taxpayers claiming an additional standard deduction for real estate or sales taxes check box 24b if filing Form 1040A or box 40b if filing Form They then complete Schedule L (Form 1040A or 1040), Standard Deduction for Certain Filers, to compute their total standard deduction. Taxpayers attach Schedule L to their tax returns to support the calculation of the standard deduction. Example 3 On June 2, 2009, Joel Raney, a single taxpayer, paid $4,200 in sales tax on the purchase of a new SUV costing $60,000 ($60,000 7% tax rate). On December 22, 2009, he paid $1,200 in real estate taxes on his principal residence. His modified AGI is $82,165. If Raney does not itemize, he can add $3,965 to his 2009 standard deduction. This amount includes $500 for real estate taxes and $3,465 ($49,500 7%) for sales tax. Example 4 Same as in Example 4, except that Raney s modified AGI is $131,180. Since modified AGI exceeds $125,000, Raney must reduce his additional standard deduction for sales tax by $2,141 ($3,465 ($6,180 excess AGI/$10,000 phase-out range). Raney would add $1,824 ($500 + ($3,465 $2,141)) to his 2009 standard deduction amount Standard Deduction for Dependents For 2009, a person (e.g., child) who qualifies as a dependent of another taxpayer (e.g., parent) computes the basic standard deduction as the greater of two amounts: (i) $950 or (ii) earned income plus $300. The deduction cannot exceed the basic standard deduction for the dependent s filing status. Any additional standard deduction for which the dependent qualifies is added to the basic standard deduction. When married taxpayers are claimed as dependents and file separate returns, special rules apply. If one or both spouses are claimed as a dependent by another taxpayer, each spouse s basic standard deduction is limited to the greater of (i) $950 or (ii) the spouse s earned income plus $300. However, if one spouse itemizes deductions, the total standard deduction for the other spouse is zero. Example 5 Sue, age 74, has no earned income and is claimed as a dependent on her son s tax return. Her 2009 basic standard deduction is limited to $950 (the greater of (i) $950 or (ii) $0 earned income + $300). Her additional standard deduction is $1,400. Sue deducts $2,350 ($950 + $1,400) from AGI when computing her 2009 taxable income

10 1 10 Essentials of Federal Income Taxation Filled-In Standard Deduction Worksheet For Dependents Information For Figure 1-1: This figure presents a filled-in Standard Deduction Worksheet for 16-year-old Gloria Moore. Gloria s parents claim her as a dependent. Gloria has perfect vision. She earned $1,400 at a weekend office job. Her standard deduction equals $1,700, the greater of (i) $950 or (ii) her $1,400 of earned income plus $300. This amount does not exceed the basic standard deduction for a single individual ($5,700). Figure 1-1: Filled-In Standard Deduction Worksheet For Dependents 1. Enter your earned income (defined below) plus $ , Enter $950 (minimum amount) Enter the larger of line 1 or line , Enter $5,700 if single ($5,700 if married filing separately; $11,400 if married filing jointly, or qualifying widow(er); $8,350 if head of household). 4. 5, Standard deduction: a. Enter the smaller of line 3 or line 4. If under 65 and not blind, this is the standard deduction. Otherwise go to line 5b. 5a. 1,700 b. If 65 or older or blind, multiply $1,400 ($1,100 if married filing jointly or separately, or surviving spouse) by the number of incidences of age and blindness. 5b. 0 c. Add lines 5a and 5b to determine standard deduction. 5c. 1,700 For purposes of computing a dependent's basic standard deduction, earned income includes salaries, tips, professional fees, and other compensation received for personal services performed. It also includes taxable scholarships and net profit from self-employment activities. 107 EXEMPTIONS Exemptions, like the standard deduction, reduce AGI. For 2009, this reduction is $3,650 for each exemption claimed. Generally, the taxpayer may claim an exemption for one s self and each person who qualifies as a dependent. If a married couple files a joint tax return, each spouse can claim a personal exemption. Exemptions provide many taxpayers with their biggest tax deductions. For example, a married taxpayer with two dependent children reduces AGI by $14,600 (4 $3,650). This amount exceeds the couple s $11,400 standard deduction Phase-Down of Exemptions When AGI reaches a certain level, the taxpayer phases down (reduces) the dollar amount of the exemption deduction. In 2009, for every $2,500 ($1,250 for MFS) of AGI (or fraction thereof) over a threshold amount, the exemption deduction goes down by one-third of 2 percentage points. However, taxpayers can never lose more than one-third of their exemption deduction. Thus, when the excess exceeds $122,500 ($61,250 for MFS), the taxpayer s deduction equals $2,433 (2/3 of $3,650) times the total number of exemptions claimed

11 Overview of the Tax Structure 1 11 Threshold Amounts Exemption Phase-Down for 2009 Filing Status Start When AGI Over Stop When AGI Over Married filing jointly $250,200 $372,700 Surviving spouse 250, ,700 Head of household 208, ,000 Single 166, ,300 Married filing separately 125, , Filled-In Personal Exemption Worksheet Information for Figure 1-2: This figure shows the phase-down worksheet for Jack and Laura Johnson. The Johnsons use the worksheet to compute the deduction for their four (two personal and two dependency) exemptions. They file jointly and have $273,760 of AGI. Figure 1-2: Filled-In Personal Exemption Worksheet Is the amount of AGI more than the amount shown on line 3 below for your filing status? NO. Stop. Multiply $3,650 by the total number of exemptions claimed. This is your exemption deduction. YES. Complete the worksheet below to figure your deduction for exemptions. 1. Multiply $3,650 by the number of exemptions claimed , Enter the amount of AGI , Enter the amount shown below for your filing status: a. Single, enter $166,800. b. Married filing jointly, or qualifying widow(er), enter $250,200. c. Married filing separately, enter $125,100. d. Head of household, enter $208, , Subtract line 3 from line 2. If zero or less, stop here; the amount from line 1 above is the exemption deduction ,560 Note: If line 4 is more than $122,500 (more than $61,250 if MFS), stop here; enter on line 9 $2,433 times the number of exemptions claimed. 5. Divide line 4 by $2,500 ($1,250 if married filing separately). If the result is not a whole number, round up to the next higher whole number (for example, round to 1) Multiply line 5 by 2% (.02) and enter the result as a decimal amount Multiply line 1 by line , Multiply line 7 by one-third (33.33%) Exemption deduction. Subtract line 8 from line ,

12 1 12 Essentials of Federal Income Taxation Example 6 Jack Emerald s AGI for 2009 is $150,102. He is married at the end of 2009, but files separately from his wife. He claims one personal exemption for himself. Because his AGI exceeds the $125,100 threshold for MFS, Emerald s personal exemption is $3,139. Initial exemption $3,650 AGI $150,102 AGI threshold for MFS (125,100) Excess AGI $ 25,002 $1, Rounded to nearest whole number $3,650 $ 1, % ( 511) Personal exemption deduction $3,139 This reduction in the personal and dependency exemption deduction for high-income taxpayers was enacted as part of the Tax Reform Act of The original tax law reduced total exemptions by 2% for each $2,500 increment ($1,250 for MFS) of AGI in excess of a threshold amount that varied by filing status. The Economic Growth and Tax Relief Reconciliation Act of 2001 repealed this limit over a four-year period. In 2006 and 2007, reduction was two-thirds of 2%. In 2008 and 2009, the reduction is one-third of 2%. After 2009, higher income taxpayers will no longer be required to reduce their exemption amounts. However, all changes made by the 2001 Tax Act (including this one) are set to expire after If that happens, then starting in 2011, the tax law will revert back to the original law requiring a full 2% phase down Personal Exemptions Normally, a taxpayer deducts a personal exemption for him or herself. However, a person who qualifies as the dependent of another taxpayer cannot take a personal exemption. The death of a taxpayer does not affect the amount of the personal exemption. The full exemption is deducted on a decedent s final return. No prorating or reduction is necessary Exemptions for Spouse Spouses are covered by special rules. A taxpayer may claim an exemption for the spouse (spousal exemption) on a joint return. When filing separately, a taxpayer may claim a spousal exemption only if the spouse: 1. Has no gross income, and 2. Does not qualify as a dependent of another taxpayer. A spousal exemption is available for a spouse when spouses are separated by a temporary (pending) divorce decree. However, if the divorce is finalized by the end of the year, the taxpayer (who is no longer married) may not claim a spousal exemption. The taxpayer takes a full exemption for a spouse who dies during the year. If the taxpayer remarries during that year, the Code denies a spousal exemption for the deceased.

13 Exemptions for Dependents Overview of the Tax Structure 1 13 The taxpayer also claims an exemption for each person who qualifies as a dependent. While minor children and elderly parents generally make up the taxpayer s list of dependents, others may qualify. Dependents fall into one of three groups: (1) qualifying children, (2) qualifying relatives, or (3) qualifying nonrelatives. Several requirements must be met if the taxpayer is to claim a dependency exemption for a person in one of these groups. Also, the tax law requires that each dependent s social security number be shown on the tax return in order to claim the exemption. 108 DEPENDENCY EXEMPTION REQUIREMENTS There are three groups of persons who may qualify as the taxpayer s dependent: a qualifying child, a qualifying relative, or a qualifying nonrelative. The following sections examine the rules for each of these groups. A dependent must meet all requirements listed for the applicable group. The taxpayer may claim an exemption for a qualified dependent, even if the dependent files a tax return. That dependent, however, cannot claim a personal exemption on his or her own return. The taxpayer may also claim a full exemption for a dependent who either was born or died during the year. An exemption cannot be claimed for a stillborn child. 109 QUALIFYING CHILD One group of persons who may qualify as a dependent includes those who meet the rules of a qualifying child. Beginning in 2009, a qualifying child must be younger than the taxpayer. In addition, a qualifying child is a person who passes each of the following six tests. 1. Relationship test for qualifying child 2. Age test 3. Residency test 4. Support test for qualifying child 5. Joint return test 6. Citizenship test Relationship Test For Qualifying Child Each of the following persons pass the relationship test for a qualifying child: Taxpayer s natural child, stepchild, adopted child, eligible foster child, or descendants of any of these children (i.e., grandchildren). An eligible foster child is a child placed with the taxpayer by an authorized agency or by a court order. Taxpayer s brothers and sisters, half-brothers and half-sisters, stepbrothers and stepsisters, or descendants of these siblings (i.e., nieces and nephews). Example 7 Mary s household includes her son, her son s daughter (Mary s granddaughter), her sister, her sister s son (Mary s nephew), her younger stepbrother, and her stepbrother s daughter (her stepniece). All of these individuals satisfy the relationship test with respect to Mary. Thus, if the other five tests are met, these persons may qualify as Mary s dependent under the dependency rules for a qualifying child

14 1 14 Essentials of Federal Income Taxation Age Test A qualifying child must be either under the age of 19, or under the age of 24 and a full-time student. The age test does not apply to children who are permanently and totally disabled. A student needs to meet the educational institution s full-time enrollment standard and attend classes during some part of each of five calendar months of the year. The institution must have a full-time faculty and course offerings plus a regular body of attending students. The qualifying child does not have to be attending school at the end of the year. If a qualifying child graduates, a taxpayer may claim an exemption if all of the dependency requirements are met. A qualifying child who has a full-time day job and attends night school cannot be a full-time student. Enrollment in correspondence or employment training courses will not qualify a person as a full-time student Residency Test A qualifying child must have the same residence as the taxpayer for more than half of the year. Temporary absences, such as those due to illness, education, business, or vacations, are ignored. Also, special rules apply to children of divorced or separated parents (see ) Support Test for Qualifying Child To pass the support test, a qualifying child must not provide over 50% of his or her own support. Support includes a variety of items, including food, clothing, education, medical and dental care, entertainment, transportation, and lodging. Support does not include scholarships received at educational institutions. For example, take a child who receives a $4,500 college scholarship in a year in which the taxpayer provides $3,800 for the child s support. If no other sources of support exist, the taxpayer meets the support requirements to claim a dependency exemption because the tax law ignores the $4,500. Thus, the taxpayer is treated as having provided all $3,800 of the child s total support. Usually the status and source of support funds make no difference. Social security income, student loans and welfare payments count if the dependent uses them to buy support items. However, the definition of support excludes amounts a state pays for training and educating a handicapped or mentally ill child. In addition, payments for life insurance and funeral expenses do not count as support Joint Return Test To qualify as the dependent of another taxpayer, a married person cannot file a joint return. However, an exception applies when the IRS treats a married couple s joint return as strictly means for claiming a refund of all prepaid taxes during the year. Generally, a joint return is a refund claim when it meets the following conditions: 1. Neither spouse is required to file a tax return (see discussion at 114), 2. A separate return filed by either spouse would not create a tax liability, and 3. The only reason for filing a return is to get a refund of all federal income taxes withheld

15 Overview of the Tax Structure 1 15 Example 8 Amy Adams provides 75% of her married daughter s support. For the year, her daughter earns $3,100 working part-time. Her son-in-law receives $4,000 of nontaxable interest. The couple lives with Adams for over half of the year. To get a refund of the income taxes withheld from her daughter s wages, the couple files a joint return. Because their combined gross income is only $3,100, the law does not require them to file a tax return (see 114). In addition, the son-in-law would have a zero tax liability on a separate return. Consequently, Adams can claim her daughter as a dependent, provided the daughter passes all of the other dependency tests Citizenship Test A dependent must be a citizen of the United States, or resident of Canada or Mexico. However, an exception exists for foreign-born children adopted by U.S. citizens living abroad. These children qualify as dependents only if they live with the taxpayer the entire year. Children not classified as a qualifying child because they do not meet all six of these tests may still qualify as dependents under the qualifying relative rules Children of Divorced or Separated Parents When a couple gets divorced or separates, one parent can claim an exemption for the child (son or daughter) if together the parents have custody of the child more than half of the year. The law gives the exemption to the parent with the longer actual custody (custodial parent). However, the custodial parent may give the exemption to the noncustodial parent. Here, the custodial parent completes Form 8332 (see Figure 1-3 at ) and gives it to the noncustodial parent. In place of Form 8332, the custodial parent may provide the noncustodial parent with a signed and dated document stating that the custodial parent (signing parent) will not claim the exemption. The release may cover one or several years. For each year affected, the noncustodial parent must attach the release statement to his or her tax return Filled-In Form 8332 Information for Figure 1-3: Using Form 8332, Anthony B. Black, the custodial parent, agrees not to claim an exemption for his daughter, Janet A. Black. The exemption belongs to Joyce C. Redding (Janet s mother), who files her tax return and Form 8332 with the IRS. The custodial parent prepares Form The form contains three parts. Part I covers the current year. Part II covers future years. Part III revokes permission to claim an exemption for future years. By completing and signing Part I, Anthony s release is only for

16 1 16 Essentials of Federal Income Taxation Figure 1-3: Filled-In Form Tie-Break Rules For Claiming A Dependency Exemption In situations where multiple taxpayers qualify to claim a qualifying child as a dependent, only one person can claim the child. Usually the eligible parties can decide amongst themselves which one will claim the qualifying child. However, when one of the persons is the child s parent, a non-parent can claim the qualifying child only if the non-parent s AGI is higher than the AGI of the parent with the highest AGI. If the parties cannot agree as to which one will claim the qualifying child, the Code provides the following tie-break rules. When only one of the child s parents is among the group of persons who qualifies to claim the child as a dependent, the dependency exemption goes to the parent. When both parents qualify to claim the child as a dependent, the exemption goes to the custodial parent (or the noncustodial parent if the custodial parent signs over the dependency exemption to the noncustodial parent, see ). When both parents qualify to claim the child as a dependent and the child spends equal amounts of time with each parent (no custodial parent), the exemption goes to the parent with the highest AGI. When neither parent qualifies to claim the child as a dependent, the dependency exemption goes to the (non-parent) taxpayer with the highest AGI who can claim the child as a dependent

17 Overview of the Tax Structure 1 17 Example 9 Hanna and her son, Jeffrey, live with Hanna s father. Hanna s AGI is $20,000; her father s AGI is $60,000. Jeffrey is a qualifying child to both Hanna and her father. As Jeffrey s mother, under the tie-break rules, Hanna is entitled to claim the dependency exemption. Example 10 Roy and Karen Oswald divorced in Their 6-year-old son, Adam, spends half of his time with each parent. Since there is no custodial parent, the tie-break rules give the dependency exemption to the parent with the higher AGI. Taxpayers use these qualifying child rules to determine their eligibility for: 1. Head of household filing status ( ) 2. The earned income credit ( ) 3. The child tax credit ( ) 4. The child and dependent care credit ( ) 110 QUALIFYING RELATIVES A second group of persons who can be claimed as a dependent are qualifying relatives of the taxpayer. A qualifying relative is anyone who meets the following five tests but does not meet the definition of a qualifying child. 1. Relationship test for qualifying relatives 2. Support test for qualifying relatives 3. Gross income test 4. Citizenship test 5. Joint return test The rules for the citizenship and joint return tests are the same as those for a qualifying child ( and ). The three remaining tests are discussed in the sections that follow Relationship Test for Qualifying Relatives The relationship test for qualifying relatives requires that the person be a relative of the taxpayer. It is not necessary that a relative live with the taxpayer to qualify as a dependent. For income tax purposes, the Code specifies the persons who qualify as a taxpayer s relatives. RELATIVES OF A TAXPAYER Brother, sister, half-brother, half-sister, stepbrother, or stepsister Child, grandchild or other descendant of the taxpayer, including a legally adopted child Stepchild of the taxpayer, but not the stepchild s descendants Parent, grandparent, or other direct ancestor (but not a foster parent, foster grandparent, etc.) Stepparent

18 1 18 Essentials of Federal Income Taxation Father-in-law, mother-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law Nephew or niece (but only if related by blood, not by marriage) Uncle or aunt (but only if related by blood, not by marriage) At the time of a couple s marriage, the tax law sets up permanent legal relationships with the in-laws that continue after the couple divorces or a spouse s death. Thus, a husband may claim an exemption for his mother-in-law after his wife s death (provided the other four dependency tests are met). Aunts, uncles, nieces, and nephews are relatives only if their relationship to the taxpayer is established by blood (not through marriage). On a joint return, relatives of either spouse may qualify as dependents. Thus, even though the aunt of one s spouse does not qualify as one s relative, on a joint return the aunt is a relative of the spouse and may qualify as the couple s dependent. Example 11 Linda s mother has two sisters, Linda s Aunt Jane and her Aunt Reva. Jane s husband is Linda s Uncle Gene. Jane and Gene have a son, Bruce, who is Linda s cousin. For tax purposes, Linda s aunts qualify as her relatives since they are related to her by blood. Her Uncle Gene is not a relative since his relationship to Linda is established by his marriage to her Aunt Jane. Cousins are not included in the definition of a relative; thus, the Code does not count Bruce as Linda s relative. Example 12 Margaret and Ken adopted Rachel shortly after her birth in Rachel and her lineal descendents (children, grandchildren, etc.) are forever relatives of both Margaret and Ken. Example 13 Dan and April were married in At the time of their marriage, April s parents permanently became Dan s mother-in-law and a father-in-law. Thus, they will qualify as Dan s relatives, even if he and April divorce or should April die Support Test for Qualifying Relatives The support test for a qualifying relative is different than for a qualifying child. For a qualifying relative to pass the support test, the taxpayer usually must provide more than 50% of the person s total support during the tax year. On a joint return, the support coming from either spouse counts. Support includes a variety of items, including food, clothing, education, medical and dental care, entertainment, transportation, and lodging. When a taxpayer furnishes a relative's lodging, the IRS treats its fair rental value as support. Fair rental value means the rent a taxpayer could expect to receive from a stranger for the same lodging. Fair rental value covers the use of one room or a proportionate share of a house. Capital items such as automobiles and furniture count as support if given to (or bought for) a relative. Support also includes wedding costs paid for a relative. As with a qualifying child, support does not include scholarships received from educational institutions, and the status and source of support funds generally makes no difference. Also, payments for life insurance and funeral expenses do not count as support. To determine if a taxpayer provides over 50% of a relative's support, the taxpayer calculates the relative's total support, which consists of three amounts:

19 Overview of the Tax Structure Fair rental value of lodging 2. Proper share of expenses incurred or paid directly to or for the relative 3. Share of household expenses (such as food, but not lodging) unrelated to specific household members Example 14 Martha s elderly parents lived with her for the entire year. Martha s parents do not pay any rent. The fair rental value of the lodging the parents use equals $3,800 ($1,900 for each parent). Martha s father receives nontaxable social security income of $3,250, which he spent equally on support items for himself and for his wife. Dental expenses for Martha s mother total $2,200. Martha paid $700 of these expenses; her brother paid $1,500. Martha s parents eat all of their meals in her home. The cost of all meals consumed in the home was $2,802. Each parent s share comes to $934 (1/3 of $2,802). The separate and combined support for Martha s parents for the year is as follows: Mother Father Total Lodging (provided by Martha) $1,900 $1,900 $3,800 Social security spent by parents 1,625 1,625 3,250 Dental expense 2, ,200 Share of food provided by Martha ,868 Total $6,659 $4,459 $11,118 Martha provided support of $3,534 ($1,900 lodging + $700 dental expense + $934 food) to her mother and $2,834 ($1,900 lodging + $934 food) to her father. Because these amounts exceed 50% of the total support for each parent, Martha passes the support test for each parent. Multiple Support Agreements Sometimes, a group of people (e.g., children) together provide for a dependent s (e.g., parent) support, but no one person (including the dependent) provides over 50% of the support. A special rule allows one member of the group to claim the exemption. The group member claiming the exemption may change from year to year. To qualify for the exemption, the group member must pass the following tests: 1. Provide more than 10% of the dependent s support, 2. Provide, with the other group members, more than 50% of the dependent s support, and 3. Meet the other four dependency tests In addition, the group must agree on the member who is to receive the exemption. It is not uncommon to rotate the dependency exemption among group members from year to year. Once the group reaches this agreement: 1. Group members who do not claim the exemption need to complete and give to the claiming member a signed statement waiving their right to claim the exemption. The statement must include: (a) the applicable year, (b) the name of person being supported, and (c) the name, address, and social security number of person waiving the exemption. 2. The claiming member holds on to this statement to support the claimed exemption. It is not filed with the tax return. 3. The claiming member completes and files Form 2120, Multiple Support Declaration, with the tax return. This form lists those eligible persons waiving their right to claim an exemption for the dependent in question

20 1 20 Essentials of Federal Income Taxation Example 15 Elaine lives with Logan for the entire year. Logan, Marty, Nancy, Michael, and Lilly provide 100% of Elaine s support. Each person s relationship to Elaine, plus the amounts of support they provided are as follows. Amounts Percentage Logan (Elaine s son) $ 1,000 10% Marty (Elaine s son-in-law) 2,500 25% Nancy (Elaine s stepdaughter) 2,500 25% Michael (Elaine s brother) 2,500 25% Lilly (Elaine s friend) 1,500 15% Total $10, % Qualifying group members include Marty, Nancy, and Michael. Logan and Lilly do not qualify as group members. Logan does not provide more than 10% of Elaine s support. Since Elaine is not one of Lilly s relatives, for Elaine to pass the relationship test, she would have to live with Lilly the entire year (discussed later in the test for qualifying nonrelatives, 111). Elaine qualifies as a relative to Marty, Nancy, and Michael. Thus, each passes the relationship test. Marty, Nancy, and Michael must decide which of them will claim the dependency exemption Filled-In Form 2120 Information for Figure 1-4: Using Form 2120, Helen B. Jones, acknowledges that she will claim the dependency exemption for Joseph R. Brown, her father. She lists Robert A. Brown as an eligible person who has provided her with a signed statement waiving his right to claim Joseph as a dependent. Figure 1-4: Filled-In Form

21 Gross Income Test Overview of the Tax Structure 1 21 To pass the gross income test, the person s gross income usually must be less than the personal exemption amount ($3,650 for 2009). In addition to wages, dividends, and taxable interest, gross income includes gross receipts from rental property before expenses are deducted. To compute the gross income of a business, cost of goods sold is subtracted from net sales and any miscellaneous income is added to the difference. Gross income includes only the income that the government taxes. Thus, it excludes a dependent s tax-exempt municipal bond interest, all Medicare benefits, and most social security benefits, since these amounts are not taxed. 111 QUALIFYING NONRELATIVES An unrelated person may qualify as the taxpayer s dependent. To qualify, a nonrelative must meet the following dependency tests that apply to relatives. 1. Citizenship test 2. Support test 3. Gross income test 4. Joint return test In addition, an unrelated person must live with the taxpayer the entire year. However, if the relationship between the person and the taxpayer is violation of local law, no dependency exemption is allowed. The death or birth of these persons will shorten the entire year requirement to that period during which they were alive. Another exception exists for temporary absences, such as attendance at school, vacations, and indefinite nursing home and hospital stays. Example 16 For the past two years, Nancy Sharp lived with her younger cousin Mary Blunt. In January, Sharp moved to a nursing home. The doctor informed Blunt that Sharp will stay in the nursing home indefinitely. For tax purposes, Sharp still lives with Blunt. Thus, if the other dependency tests are met, Blunt can claim a dependency exemption for Sharp. The fact that Sharp is older than Blunt is irrelevant. The rule that the dependent be younger than the taxpayer only applies to qualifying children. 112 TAX BASE FORMULA ANOTHER VIEW Figure 1-5 provides another view of the tax base formula. It should enhance the meaning of new tax terms and concepts. 112