Topic-7 Individual Income tax Computation.doc

McGraw-Hills Taxation, by Spilker et al.Topic 7Individual Income Tax Computation and Tax CreditsDiscussion Questions1.What is a tax bracket? What is the relationship between filing status and the width of the tax brackets in the tax rate schedule?A tax bracket is a range of taxable income that is taxed at a specified tax rate. Because only the income in the particular range is taxed at the specified rate, tax brackets are often referred to as marginal tax brackets or marginal tax rates. The level and width of the brackets depend on the taxpayers filing status. The tax rate schedules include six tax rate brackets. The rates for these brackets are 10%, 15%, 25%, 28%, 33%, and 35%. In general, the tax brackets are widest for Married filing jointly (for example, more income is taxed at 10%), followed by Head of household, Single, and then Married filing separately (the brackets for Married filing separately are exactly one-half the width of the brackets for Married filing jointly and the width of the 10% and 15% brackets for Single and Married filing separately are the same).2. In 2010, for a taxpayer with $50,000 of taxable income, without doing any actual computations, which filing status do you expect to provide the lowest tax liability? Which filing status provides the highest tax liability?For a taxpayer with $50,000, the married filing jointly filing status should provide the lowest tax liability in 2010 because the MFJ tax rate schedule taxes more of this income at 10% and 15% than the other rate schedules (the 10% and 15% tax brackets are wider). Conversely, the married filing separately and the single filing statuses will generate the highest tax liability because a smaller amount of income is taxed at 10% and 15% (the 10% and 15% tax brackets are more narrow) than other tax rate schedules.3. What is the tax marriage penalty and when does it apply? Under what circumstances would a couple experience a tax marriage benefit?A marriage penalty (benefit) occurs when, for a given level of income, a married couple has a greater (lesser) tax liability when they use 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 would have used the single tax rate schedule to compute the tax on each spouses individual income. The marriage penalty applies to couples with two wage earners while a marriage benefit applies to couples with single breadwinners. 4. Once theyve computed their taxable income, how do taxpayers determine their regular tax liability? What additional steps must taxpayers take to compute their tax liability when they have preferentially taxed income?Once taxpayers have determined their taxable income, they should split the income into two portions: (1) ordinary income and (2) income taxed at preferential rates (if any), and compute tax on each portion separately. Taxpayers compute the tax on the ordinary income portion by applying the appropriate tax rate schedule (based on their filing status). Taxpayers generally compute their tax on the preferentially taxed income by multiplying the amount of income by 15%. However, to the extent that it would have been taxed at a rate of 15% or l0% if it were ordinary income, the preferentially taxed income (dividends and long-term capital gains) is taxed at 0% in 2010. A taxpayers total regular income tax liability is the sum of the tax on ordinary income and the tax on preferentially taxed income. 5. Are there circumstances in which preferentially taxed income (long-term capital gains and qualified dividends) is taxed at the same rate as ordinary income? Explain.Generally, no. If the preferentially taxed income would have been taxed at 10% or 15% if it were ordinary income, it is taxed at a lower 0% rate. If it would have been taxed at a rate higher than 15%, it is taxed at 15%. This is why we refer to the income as preferentially taxed income. There are certain types of long-term capital gains that are taxed at a maximum rate of 25% (unrecaptured 1250 gain) and 28% (capital gains from collectibles). These gains are taxed at the taxpayers marginal ordinary rate unless the ordinary rate exceeds the maximum rate. Then these gains are taxed at the maximum rate. However, we did not address these special situations in this chapter (thats why this is a research question). See 1(h)(1).6. Augustana received $10,000 of qualified dividends this year. Under what circumstances would all $10,000 be taxed at the same rate? Under what circumstances might the entire $10,000 of income not be taxed at the same rate?The entire qualified dividend will be taxed at the same rate in two scenarios. First, the dividend will all be taxed at 15% if Augustanas ordinary income exceeds the threshold for the 15% marginal tax bracket (it is taxed at a rate higher than 15%). Second, the entire dividend will be taxed at 0% as long as the Augustanas ordinary income plus her $10,000 qualified dividend does not exceed the threshold for the 15% marginal tax bracket.The qualified dividend will be taxed at different rates if the amount of Augustanas ordinary income is below the 15% marginal tax bracket but the qualified dividend causes her total taxable income to exceed the 15% marginal tax bracket threshold. In this scenario, her qualified dividends will be taxed at 0% to the extent they would have been taxed at 15% as ordinary income and the remainder would be taxed at 15%.7. What is the difference between earned and unearned income?Earned income is income earned by the taxpayer from services or labor. Unearned income is from investment property such as dividends from stocks or interest from bonds.8. Does the kiddie tax eliminate the tax benefits gained by a family when parents transfer income-producing assets to children? Explain.No. Though the kiddie tax significantly limits the benefit of shifting income producing assets to children, it does not eliminate it. The kiddie tax does not apply unless the child has unearned investment income in excess of $1,900 ($950 standard deduction plus an additional $950). That is, parents can shift up to $1,900 of unearned investment income to a child without the child paying the kiddie tax (paying tax on income at the parents marginal tax rate).9. Does the kiddie tax apply to all children no matter their age? Explain.No, the kiddie tax applies to children who have net unearned income in excess of $1,900 if the children (1) are under age 18 at the end of the year, (2) are age 18 at the end of the year and do not have earned income in excess of half of their support, or (3) are over age 18 and under age 24, are full-time students, and dont have earned income in excess of half of their support (excluding scholarships).10. What is the kiddie tax and on whose tax return is the kiddie tax liability reported? Explain.The kiddie tax is a tax at the parents marginal rate on the childs unearned income in excess of $1,900. Generally, the kiddie tax liability is reported on the childs tax return. However, the parents can make an election to include on their own return the childs gross income in excess of $1,900.Problems11. Whitney received $75,000 of taxable income in 2010. All of the income was salary from her employer. What is her income tax liability in each of the following alternative situations?a. She files under the single filing status.Whitney has an income tax liability of $14,931.DescriptionAmountComputation(1) Taxable income$75,000(2) Income tax liability$14,931.25(75,000 34,000) x 25% + 4,681.25 (see tax rate schedule for Single individuals)b. She files a joint tax return with her spouse. Together their taxable income is $75,000.Whitney has an income tax liability of $11,125.DescriptionAmountComputation(1) Taxable income$75,000(2) Income tax liability$11,112.50(75,000 68,000) x 25% + 9,362.50 (see tax rate schedule for Married Filing Jointly)c. She is married but files a separate tax return. Her taxable income is $75,000.Whitney has an income tax liability of $15,132.DescriptionAmountComputation(1) Taxable income$75,000(2) Income tax liability$15,121.75(75,000 68,650) x 28% + 13,343.75 (see tax rate schedule for Married Filing Separately)d. She files as a head of household.Whitney has an income tax liability of $13,603.DescriptionAmountComputation(1) Taxable income$75,000(2) Income tax liability$13,597.50(75,000 45,550) x 25% + 6,235 (see tax rate schedule for Head of Household)12. In 2010, Lisa and Fred, a married couple, have taxable income of $300,000. If they were to file separate tax returns, Lisa would have reported taxable income of $125,000 and Fred would have reported taxable income of $175,000. What is the couples marriage penalty or benefit?The couple would have a marriage penalty of $5,205. That is they pay $5,205 more in taxes by filing jointly than their combined tax liability if they each had filed as a single taxpayer. 2010 Marriage penalty or (benefit)Two income vs. Single income married coupleMarried coupleTaxable incomeTax if fileJointly(1)Tax if file Single(2)Marriage penalty (benefit)(1) (2) Wife (Lisa)$125,000$28,709 Husband (Fred)175,00042,867Combined$300,000$76,781*$71,576$5,205*$46,833.50 + (300,000 - 209,250) .33$16,781.25 + (125,000 82,400) .28$41,827.25 + (175,000 171,850) .33 13. In 2010, Jasmine and Thomas, a married couple, have taxable income of $150,000. If they were to file separate tax returns, Jasmine would have reported taxable income of $140,000 and Thomas would have reported taxable income of $10,000. What is the couples marriage penalty or benefit?The couple would have a marriage benefit of $3,746. That is they pay $3,746 less in taxes by filing jointly than their combined tax liability if they each would have filed as single taxpayer.2010 Marriage penalty or (benefit)Two income vs. Single income married coupleMarried coupleTaxable incomeTax if fileJointly(1)Tax if file Single(2)Marriage penalty (benefit)(1) (2) Wife (Jasmine)$140,000$32,909 Husband (Thomas)10,0001,081Combined$150,000$30,244*$33,990$(3,746)*$26,687.5 + (150,000 137,300) .28 $16,781.25 + (140,000 82,400) .28$837.5 + (10,000 8,375) .15 14.Lacy is a single taxpayer. In 2010, her taxable income is $37,000. What is her tax liability in each of the following alternative situations?a. All of her income is salary from her employer.Lacys total tax is $5,431.25.DescriptionAmountExplanation(1) Taxable income$37,000(2) Preferentially taxed income0(3) Income taxed at ordinary rates37,000(1) (2)(4) Tax on income taxed at ordinary rates$5,431.25(37,000 34,000) 25% + 4,681.25 (see tax rate schedule for Single individuals)(5) Tax on preferentially taxed income0Tax on taxable income$5,431.25(4) + (5)b. Her $37,000 of taxable income includes $2,000 of qualified dividends.Lacys total tax is $5,231.25.DescriptionAmountExplanation(1) Taxable income$37,000(2) Preferentially taxed income2,000(3) Income taxed at ordinary rates35,000(1) (2)(4) Tax on income taxed at ordinary rates4,931.25(35,000 34,000) 25% + 4,681.25(5) Tax on preferentially taxed income300(2) 15% Note that if (2) were ordinary income it would have been taxed at 25%Tax on taxable income$5,231.25(4) + (5)c. Her $37,000 of taxable income includes $5,000 of qualified dividends.Lacys total tax is $4,831.25.DescriptionAmountExplanation(1) Taxable income$37,000(2) Preferentially taxed income5,000(3) Income taxed at ordinary rates32,000(1) (2)(4) Tax on income taxed at ordinary rates4,381.25(32,000 8,375) 15% + 837.50(5) Tax on preferentially taxed income450(34,000 32,000) 0% + (5,000 (34,000 32,000) 15%Tax on taxable income$4,831.25(4) + (5)Comprehensive Problems15. In 2010, Jack and Diane Heart are married with two children, ages 10 and 12. Jack works full-time and earns an annual salary of $75,000, while Diane works as a substitute teacher and earns approximately $25,000 per year. Jack and Diane expect to file jointly and do not itemize their deductions. In the fall of this year, Diane was offered a full time teaching position that would pay her an additional $20,000. a. Calculate the marginal tax rate on the additional income, excluding employment taxes, to help Jack and Diane evaluate the offer.If Diane refuses the position, the Hearts 2010 AGI is $100,000, their taxable income is $74,000 $100,000 - 11,400 - 14,600 and their gross tax is $10,862.50. Their marginal tax rate is 25%. Because the Hearts qualify for $2,000 of child tax credit (2 $1,000) and $800 of making work pay credit, their net tax is $8,062.50. If Diane accepts the position, then their AGI and taxable income will increase by $20,000 and they will remain in the 25% tax bracket. Thus, their gross tax will increase by $5,000. However, since their AGI is now $120,000, it triggers the phase-out of the child tax credit. Their increased AGI exceeds the phase-out threshold by $10,000 which reduces their child tax credit by $500 $50 10 (10,000 / 1,000). Hence, the Hearts net tax on the income increases by $5,500 and their effective marginal tax rate on the income is 27.5% ($5,500/$20,000).DescriptionDecline OfferAccept OfferReference(1) AGI$100,000$120,00075,000 + 25,000 +20,000 (if accepted)(2) Standard deduction11,40011,400MFJ standard deduction(3) Exemptions14,60014,6003,650 x 4(4) Taxable income$74,000$94,000(1) (2) (3)(5) Tax liability$10,862.50$15,862.50See tax tables for MFJ(6) Child tax credit(2,000)(1,500)See analysis above(7) Making work pay credit(800)(800)$800 maximum credit (not phased-out) (8) Tax due/(refund)$8,062.50$13,562.50(5) + (6) + (7)(9) Net tax increase if offer is accepted5,50013,562.50 8,062.50Marginal tax if offer is accepted27.5%5,500 / 20,000b. Calculate the marginal tax rate on the additional income, including employment taxes, to help Jack and Diane evaluate the offer.If Diane refuses the position, the Hearts 2010 AGI is $100,000, their taxable income is $74,000 $100,000 - 11,400 - 14,600 and their gross tax is $10,862.50. Their marginal tax rate is 25%. Because the Hearts qualify for $2,000 of child tax credit (2 $1,000) and $800 of making work pay credit, their net tax is $8,062.50. Jacks FICA taxes are $5,738 and Dianes FICA taxes are $1,913. So, the Hearts total tax liability without the additional income is $15,713.50 ($8,062.5 + $5,738 + $1,913)If Diane accepts the position, then their AGI and taxable income will increase by $20,000 and they will remain in the 25% tax bracket. Thus, their gross tax will increase by $5,000. However, since their AGI is now $120,000, it triggers the phase-out of the child tax credit. Their increased AGI exceeds the phase-out threshold by $10,000 which reduces their child tax credit by $500 $50 10 (10,000 / 1,000). Hence, the Hearts net tax regular tax increases by $5,500 the change in the gross tax plus the phase out the child tax credit. Also, their FICA taxes increase by $1,530 ($20,000 .0765). So their overall taxes increase by $7,030 ($5,500 + $1,530). Their marginal tax rate on the $20,000 of income is 35.15%.DescriptionDecline OfferAccept OfferReference(1) AGI$100,000$120,00075,000 + 25,000 +20,000 (if accepted)(2) Standard deduction11,40011,400MFJ standard deduction(3) Exemptions14,60014,6003,650 4(4) Taxable income$74,000$94,000(1) (2) (3)(5) Tax liability$10,862.50$15,862.50See tax tables for MFJ(6) Child tax credit(2,000)(1,500)See analysis above(7) Making work pay credit(800)(800)$800 maximum, not phased-out(8) Employment taxes7,6519,181See analysis above(9) Tax due/(refund)$15,713.50$22,743.50Sum of (5) through (8)(10) Net tax increase if offer is accepted7,03022,743.50 15,713.50 Marginal tax if offer is accepted35.15%7,030 / 20,000c.Calculate the marginal tax rate on the additional income, including self-employment taxes, if Diane would be working as a self employed contractor.If Diane accepts the job, she will be required to pay self-employment taxes on the additional $20,000 of income. Her self-employment tax liability is $2,826 ($20,000 92.35% 15.3%). She is allowed to deduct half of the self employment taxes ($1,413) as a for AGI deduction. So, the increase in the Hearts AGI from the additional income is $18,587 ($20,000 1,413) giving them AGI of $118,587. The Hearts increase in taxable income due to the additional $20,000 of self-employment income is $18,587. Because their taxable income level puts them in the 25% bracket this income increases their regular tax liability by $4,647 ($18,587 25%). Also, because their AGI is now $118,587 it triggers the phase-out of the child credit. The AGI exceeds the phase-out threshold by $8,587 reducing the child tax credit by $450 $50 9 (8,587 / 1,000 (rounded up to 9). Hence, the Hearts net regular tax increases by $5,097 ($4,647 additional tax + $450 reduction in child tax credit) the change in the gross tax plus the phase out the child credit. In summary, the Hearts regular tax increases by $5,097 and their self-employ