Overview of the Tax Structure

Overview of the Tax Structure 2007, CCH INCORPORATED 4025 West Peterson Ave. Chicago, IL 60646-6085 http://www.cch.com 1 of 35

3 of 35

Responsibilities of Taxpayers Prepare appropriate tax forms and schedules Determine correct tax liability Pay tax due on time File return on time with proper IRS Regional Service Center and keep evidence of on-time mailing Maintain records and documents to support tax return data Try to minimize tax return errors 4 of 35

Taxable Income Formula Income from all sources Exempt income = Gross income Deductions = Taxable income 5 of 35

Which Form do I file? Individuals choose one of three tax forms: 1040EZ (no dependents) 1040A (limited sources of income) 1040 (all others) Wisconsin tax forms 6 of 35

Tax Filing Groups Single Head of household Married filing a joint return Married filing a separate return Surviving spouse (a qualifying widow or widower with a dependent child) 7 of 35

Basic Tax Formula for Individuals Income from all sources Exempt income = Gross income Deductions for AGI (adjusted gross income) = AGI Deductions from AGI Itemized or standard deduction Exemptions (personal and dependency) = Taxable income Tax Rate = Tax liability before: + Additions to tax Credits to tax = Final tax due (refund) 8 of 35

Let s try a simple example Ann, a single taxpayer, has no dependents. Her only source if income is from wages she has earned for the year, totalling $26,450. What is the amount of Ann s federal income tax liabilty for the year? Ann has no tax credits; her income is over the earned income credit limit. 9 of 35

Basic Tax Formula for Ann Income from all sources Exempt income = Gross income Deductions for AGI (adjusted gross income) = AGI Deductions from AGI Itemized or standard deduction Exemptions (personal and dependency) = Taxable income Tax Rate = Tax liability before: + Additions to tax (- Telephone tax refund) Credits to tax = Final tax due (refund) 10 of 35

Compensation for services, including fees, commissions, fringe benefits, and similar items Gross income from business Property transaction gains Interest Rents Royalties Dividends Alimony and separate maintenance payments Gross Income The Code lists the following different gross income sources (and implies that others exist): Annuities Life insurance and endowment contract income Pensions Income from forgiven debt Share of distributive partnership income Income in respect of a decedent Income from an interest in an estate or trust 11 of 35

Deductions for AGI Trade and business deductions Losses from property transactions involving business and investment property Partner s distributive share of partnership loss Shareholder s pro rata share of S corporation loss Deductions related to rental and royalty income Contributions to qualified retirement plans of selfemployed individuals Contributions to traditional IRAs Penalty for early withdrawal from certificates of deposits Alimony and separation maintenance payments 12 of 32

Deductions for AGI (continued) Qualified moving expenses One-half self-employment tax 100% of health insurance premiums paid by a selfemployed person Contributions made to medical or health savings accounts Interest paid on student loans Certain expenses of reservists, performing artists, and fee-based government officials Deduction for domestic production activities Educator s expenses Deduction for tuition and fees 13 of 32

Medical Taxes Interest Contributions Deductions from AGI (itemized deductions) Casualty and theft losses Job expenses and some miscellaneous deductions Other miscellaneous deductions 14 of 35

Standard Deduction The standard deduction consists of two factors: Basic standard deduction (M, HOH, S) $10,700; 7,850; 5,350 Additional standard deduction $1,050 or 1,350 for HOH & S 15 of 35

Greater of: Standard Deduction-- Dependents o $850 or o Earned Income plus $300 o But cannot > $5,350 See text figure 1-1 16 of 35

Exemptions $3,400 Exemption for self Exemption for spouse Exemptions for dependents Qualifying relatives Qualifying nonrelatives Qualifying children 17 of 35

Phase-down of Exemptions Reduces or eliminates amount of exemption Depends on Filing Status Exemption is lost when AGI exceeds maximum amounts See Figure 1-2 in text 18 of 35

Who is a dependent? Let s brainstorm. In a small group, make a list of any person who you know who is financially dependent on another person. We don t want names, but rather how these persons are connected. Think of situations you know of personally, as well as situations which may occur in various aspects of life. 19 of 35

Dependency groups 1. A relative dependent 2. A non-relative dependent 3. A child 20 of 35

Dependency Exemption Requirements if a Relative Relative p. 1-17 U.S. citizen or resident of U.S., Canada, or Mexico Support of more than 50% Gross income less than exemption amount Dependent does not file a joint return 21 of 35

Gross Income Test see page 1-16 Dependent s gross income must be <$3400 EXCEPTIONS: if child and under age 19 if child is full-time student under age 24 do not count Soc. Sec., Medicare, or exempt interest the dependent may receive 22 of 35

Dependency Exemption Requirements for Nonrelatives U.S. citizen or resident of U.S., Canada, or Mexico Support of more than 50% Gross income less than exemption amount Does not file joint return if married Live with taxpayer for entire year 23 of 35

Criteria for Qualifying Children Does not provide over half of own support Does not file a joint return (if married) Is a U.S. citizen or resident of the U.S., Canada or Mexico Passes the relationship test by being the taxpayer s descendent (child, grandchild, etc.), sibling (sister or brother) or descendent of the taxpayer s sibling (niece or nephew) Passes the age test by being under age under 19 or a full-time student under age 24 Passes the residency test by having as a principal residence the taxpayer s home 24 of 35

Calculation of Dependent s Support A dependent s support consists of these three amounts: Fair rental value of lodging Proper share of expenses incurred or paid directly to or for the dependent Share of household expenses (such as food but not lodging) unrelated to specific household members 25 of 35

Multiple Support Agreement The group member claiming the exemption must pass the following tests: Provide more than 10% of the dependent s support Provide, with the other group members, more than 50% of the dependent s support Meet the other dependency tests Group members who do not claim the exemption need to complete and deliver a Form 2120 to the claiming member. By signing the form, they agree not to claim the exemption for that year. See p. 1-20. The claiming member needs to file the Forms 2120 with the year s tax return. 26 of 35

Dependency Exemption for Child of Divorced or Separated Parents Unless there is a written agreement to the contrary, the custodial parent receives the exemption if the parents acting together: Provide more than 50% of the child s support Have custody of the child more than 50% of the year 27 of 35

Tie Break Rules for the Dependency Exemption 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. When both parents qualify to claim the child as a dependent and there is 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. 28 of 32

Joint Return Test A married taxpayer cannot file a joint return and also be claimed as a dependent by another taxpayer unless: Neither spouse is required to file a tax return A separate return filed by either spouse would not create a tax liability The only reason for filing a return is to get a refund of withheld taxes 29 of 35

30 of 35

FILING STATUS Single Taxpayer Persons who fall into this group include: Unmarried persons Persons separated by a final divorce decree or separate maintenance agreement Certain widow(er)s and abandoned spouses 31 of 35

Head of Household (HOH) For HOH status to apply, the taxpayer must meet one of the following two tests: The taxpayer maintains a home for more than 50% of the year and lives in it with one of the following: An unmarried natural, step-, or adopted child, or grandchild of the taxpayer A married natural, step-, or adopted child or grandchild who qualifies as the taxpayer s dependent A dependent foster child who qualifies as the taxpayer s natural child for HOH purposes Other relatives who qualify as a dependent of the taxpayer The taxpayer maintains a household for a parent for more than 50% of the year 32 of 35

Joint Return Test A married taxpayer cannot file a joint return and also be claimed as a dependent by another taxpayer unless: Neither spouse is required to file a tax return, A separate return filed by either spouse would not create a tax liability, and The only reason for filing a return is to get a refund of all federal income taxes withheld 33 of 32

Married Filing a Joint Return A husband and wife qualify to file a joint return even if only one has income. If both have income, they need to use the same tax year to file jointly. A single taxpayer who gets married before the end of the year qualifies to file a joint return. The taxpayer s marital status at the close of the year, or at the spouse s death, governs. 34 of 32

Married Filing a Separate Return When a husband and a wife have separate incomes, they may realize savings by filing separate returns. Taxpayers should test joint and separate return status to see which one yields the least tax liability. 35 of 35

Surviving Spouse (Qualifying Widow[er] with Dependent Child) To qualify for surviving spouse status, a widow(er) must: Qualify to file a joint return with the deceased spouse in the year of death Maintain a home for himself or herself and his or her dependent child Live with the qualifying child for the entire year Not remarry before the end of the year Uses Married-Joint rates for 2 years after spouse s death 36 of 35

Married Filing a Joint Return A husband and wife qualify to file a joint return even if only one has income. If both have income, they need to use the same tax year to file jointly. A single taxpayer who gets married before the end of the year qualifies to file a joint return. The taxpayer s marital status at the close of the year, or at the spouse s death, governs. 37 of 32

Married Filing a Separate Return When a husband and a wife have separate incomes, they may realize savings by filing separate returns. Taxpayers should test joint and separate return status to see which one yields the least tax liability. 38 of 32

Filing Requirements for Persons Not Claimed as a Dependent A tax return must be filed when: Net earnings from self-employment > $400, or Gross income > personal exemption amount + basic standard deduction + additional standard deduction for age (if applicable) If MFS, a return must be filed if gross income exceeds the personal CCH Essentials of exemption Federal amount 39 of 32

Filing Requirements for Persons Claimed as a Dependent A tax return must be filed when: Gross income > the sum of additional standard deductions for age and blindness (if applicable) plus the greater of (i) $850 or (ii) earned income (up to $5,050) +$300, or Unearned income > $850 + additional standard deductions for age and blindness (if applicable) 40 of 32

Minimize Errors Get appropriate forms, schedules, and instructions Study the instructions and assemble data before preparing the return Enter data on a tax organizer (if available) Review IRS identification label for correct facts Supply all data Check all calculations 41 of 35 Look for minor omissions due to carelessness

Statutory Limit for Assessing Normal Limit Additional Taxes Three years after the later of the return s due date or the filing date Income Omissions Six years after the later of the return s due date or the filing date for taxpayer s inadvertent omission of more than 25% of gross income reported on return Fraudulent Return Tax year never closes 42 of 35

Capital Assets Capital assets are defined as all property except: Property held for resale (inventory) Real and depreciable property used in a trade or business Accounts receivable acquired in normal business operations Artistic works created by the taxpayer 43 of 35

Capital Assets Capital assets are associated with investments such as stocks, bonds, mutual funds, or other investments. Capital assets may be any other asset the taxpayer owns not on the preceding list Capital assets are taxed differently from ordinary or earned income 44 of 46

Capital Assets Capital assets are classified as either : Short term if owned for 12 months or less Gains are taxed at the taxpayers marginal tax rate Long term if owned for more than 12 months Gains are taxed at 5% if taxpayer is in 10 15% bracket 15% if taxpayer is in 25% or above Losses up to $3,000 are deductible against other income 45 of 35

Tax Planning Principles Acquire working knowledge of tax laws Plan transactions in advance to reduce taxes Maximize unrealized income Keep good records 46 of 35