Overview
Tax return structure is more complex for individuals than for corporations, for two reasons.
First, the tax rate schedules and standard allowances vary so that tax liability can reflect assumptions about the way family support obligations affect ability to pay.
Second, individuals spend money on staying alive and having fun, as well as on seeking income. "Personal, family and living expenses" are generally nondeductible, but there are exceptions. As a result, individuals have to categorize their deductions as costs of doing business, costs of non-business income, and those limited personal living costs that the law allows.
The traditional algorithm for computing taxable income
1) Calculate "total income"
1040 l. 22: the total of wages, interest, etc.
Calculation reflects net numbers (can be negative, reflecting losses) from Schedules C, D, E and F, which means that costs of business, landlording, farming and capital losses have already been subtracted. There is no line on a return that corresponds to Sec. 61 "gross income"
Note also that some of the numbers here, such as landlord losses and soc sec. benefits, are themselves affected by line 33 AGI. Result is a "loop": 1st calculate a tentative ("modified") agi, and then use that to calculate items making up "total income" and AGI
2) Subtract adjustments to arrive at AGI
These are "non-itemized" deductions, for things like retirement plan contributions, alimony paid, student loan interest, moving expenses, and some self-employment items. They have a preferred status as compared to the "itemized deductions", and are sometimes called "above-the-line" deductions.
There are many specialized adjustments w/o any line on the form -- they get squeezed in on line 32
Again, some of these amounts, such as student loan interest and IRA contributions, may be affected by line 33 AGI. Need to 1st calculate a tentative ("modified") agi, and then use that to calculate the amount of adjustments.
3) Subtract standard/itemized deduction from AGI
Subtract the greater of standard/itemized
Standard is set by filing status, w/ $900/$1,100 enhancement if over 65 and if blind. Query who benefits.
Itemized is taken from schedule A, which lists those personal expenses that may be deducted, like some state taxes, home mortgage interest, charitable gifts and hardship medical and casualty losses. Some investment costs (eg. interest and management fees), and some costs of business (eg. out-of-pocket employee expenses) are also on that schedule.
Tax planning: "bunching" deductions
Itemized total below the standard deduction is wasted, so consider changing time of payment in order to bring total above standard amount in alternate years
Tax complication: Itemized deduction phaseout
Reduce itemized deductions by: 3% * (AGI - a threshhold) Threshhold was @ $128,950 MFJ '00)
Purpose: deliberately mis-measure income so as to increase the tax amount without increasing the stated rate. Was and is a political attempt to fool people as to how high the tax rates really are.
The "still get at least 20% of the itemized deduction rule" mentioned in text applies mathematically only when income is over $1 million
4) Subtract exemption amount for self, "dependents"
Subtract allowances ("exemptions") for self, spouse and "deductible dependents". This was $2,900 each for year 2001. Result is taxable income.
In effect, each person has a $2,900 "zero bracket" that is transferable to the person who provides their economic support
"Deductible dependents"
A complex multi-part definition:
Dependent is >50% supported, considering the necessities and small luxuries of life.
- Child in divorce is claimed by custodial parent unless written otherwise
- Several who together provide >50% support can agree to allocate the exemption
Dependent must be "related" to Tp (w/in 2 degrees) or must live with Tp
Dependent must be US citizen, or resident of US, Can or Mex (or be adopted child of citizen residing abroad )
Dependent's own gross income must be under the exemption amount, unless
Dependent is Tp's child < age 19 or Tp's child and full-time student < age 24.
This screens out most potential dependents except children.
Effect of dependency
Exemption moves to the tax return of the person claiming the dependent, and dependent does not get their own exemption. Eg. parent claims exemption for child, who then gets no exemption.
Also, dependent's standard deduction is limited: [($250 + earned income) but at least $750, and not to exceed $4,450].
The choice of who receives other tax benefits (eg. college tuition and earned income credits) has been linked to support/dependency
Complication: the exemption amount phaseout
Another complicating "hide the true rate" rule. Reduce each exemption by 2% of (AGI - $128,950 Single/ $193.4K MFJ) divided by $2,500 and rounded up
Filing Status
At the beginning of US system, tax was completely individualistic. Problems with community property income-splitting led @ 1948 to allowing H and W the option of filing as an "economic unit".
There are now four status categories (with two special classification rules) and each has its own standard deduction amount and tax rate schedule (see text front inside cover)
Married Filing Jointly
Use MFJ or MFS if married on the last day of the year. MFJ also available if spouse died during year
H&W combine income on one form signed by both, regardless of who earned or got the income.
Can be liability problems if they divorce while owing taxes, or if 1 cheated, unknown to the other
Marriage increases tax if H&W have roughly equal incomes, and decreases it if incomes are very unequal
Surviving Spouse calssification rule
If spouse died last year or year before, and survivor has deductible dependant child, can use MFJ. Is hardship relief (worth most to high bracket folks, tho)
Married Filing Separately
Use if married on last day but not MFJ. Generally has least favorable rates and rules, so usu. chosen for nontax reasons. (There can be exceptions, tho)
Note problem in community property states as to what income goes on what return
Head of Household
different standard deduction and rates for certain unmarrieds w/ family responsibilities
Maintain household (pay >50% rent & groceries) for child, or deductible dependent relative, or parent living elsewhere
Abandoned spouse classification rule
Relief rule: certain MFS w/ deductible dependant child can file as HoH
Single
A residual category. Note that child is a separate taxpayer, taxed on child's own income. (Tho there is an option to report on parents' return in some cases.)
Confused? Here's how the IRS explains taxation of the family
Transfers between generations
Parents supporting minor children
Meeting a support obligation isn't a gift, isn't income and by itself creates no deduction
Transfers without legal obligation
A gift is not income. An inheritance is not income. A gift is deductible only if made to a charitable organization.
A donor/estate pays a non-income gift or estate tax on large wealth transfers (in excess of $11K gift per recipient per year, plus a $1mm cumulative lifetime allowance) .
Husband - Wife transfers
The gift/estate tax does not apply to transfers between Husband and Wife.
Transfers Incident to divorce
Alimony (Cash to ex spouse over time, ending on death or remarriage) is income to recipient and an "adjustment" deduction for payor
Child Support isn't income or deduction
Property settlement isn't income or deduction
Note potential for negotiated tax savings here
Procedure:
- Calculate income tax liability (schedule D worksheet if capital gains)
- Subtract credits in 1st group: child, child care, Foreign
- Add other taxes: SET, AMT, Schedule H household employees, etc.
- Subtract credits in 2nd group: withholding, EIC, etc
- Result is the balance due or refund
Effect
- Some credits "refundable" (eg. EIC), some not.
- Some carry to other years (eg FTC), some don't
- Some can offset AMT, some can't
Family Tax Credits
Unlike deductions, credits reduce the tax directly. A credit is in effect a government subsidy or payment being run through the tax system
Child Credit
Enacted @1998 as a "pro-family" tax break. Very large item: there are approx 50 million qualifying children -- $25+ billion per year in family tax relief
General rule: a child under 17 at year-end is worth $500 to the person who claims that child as a dependent (Set to increase to $1K under year 2001 tax act)
"Child"= son, daughter, grandchild/"descendant", stepchild, adopted or foster. Must be US citizen or resident alien. To claim, must include child's SSN on return
Problems with the child credit
Limit at the high end: a phase-out when AGI> $110K MFJ/ $75K if single. Formula decreases the credit by $50 for each $1K above the phase-out trigger. $11,001 of income phases out one $600 child. Also a potential interaction with alternative minimum tax -- Congress passed a temporary reprieve
Limit at the low end. Credit is non-refundable, so if all "personal" credits (child, childcare etc.) exceed the tax liability, the excess is wasted. Result is that low income earners don't benefit much or at all. This led to a further adjustment: "partial refundablity, depending on excess of soc sec taxes withheld over EIC taken" -- a complicated set of calculations, amended in 2001.
Child Care Credit
Policy: subsidize child care that increases labor force participation
Qualifications: Tp maintains household with deductible dependent under 13 (or disabled dep. child or spouse) and has employment-related expenses: babysitters, daycare, maids, etc.
Mechanics: Credit is a % of the expense (w/ a max expense limited to income and also limited to $2,400 or $4,800). The %% depends on AGI: 30% if AGi <$10K, phase-down to 20% for AGI > $30K. Must put SSN of the care provider on return.
Note: the ranges and percentages are changing due to recent amendments
DCA Alternative
Alternative to credit: a tax-free fringe benefit where Employer reduces taxable pay by an amount agreed in advance ($5K/yr maximum), and uses fund to reimburse Tp's expenses for child care. Q which is better, given "use it or lose it" of DCA
Earned Income Credit
Underlying policy: a refundable work subsidy geared to # of children
Qualifications: Tp is age 25 to 65 (at yearend), is not MFS, and has earned income. Limited EIC for NRA's
Calculation: a percent of earnings, up to a maximum credit, and then a phase-out that decreases the credit as income rises further
EIC issues:
Complexity: many eligibles didn't claim; many claimants are ineligible
Fraud: it's profitable for the poor to overreport income. Result is redirection of IRS compliance work -- higher audit rate for the poor than for the rich.
Extremely high effective marginal rates in the phaseout zone, and a huge potential marriage penalty
Lump sum payment -- will it really be spent on the child?
New Study - Sept. 2002: Massive increase in number of taxpayers subject to AMT predicted unless extremely expensive changes are enacted
The Fairmark Guide to the AMT is here
Policy background
started with a 1969 treasury study: about 400 Tp's over $200K AGI had no tax liability. (Not as bad as it seems -- casualty, investment interest, foreign tax credit were usual causes)
Result: a perceived political need to prevent high income folks from zeroing out tax liability thru "loopholes". The first "minimum tax" didn't work, so "Alt" min tax was created @1982. Broadened and expended in 1986
Goal of 1986 Tax Reform: shut loopholes -- and also pick up a short term revenue fix. Was compromise of reform and expediency. An embryonic flat tax.
Mechanics
Calculate an alternate tax using alternate rates (lower) and an alternate definition of income: "Alt Min Taxable Income". (Fewer deductions and less favorable timing rules). If the alternate tax number is higher than the regular number, pay the difference as "AMT"
How income is redefined into AMTI:
Don't allow certain deductions: "exclusion preferences"
- State taxes (what about state tax refunds. Income? AMT tax benefit rule)
- All Misc itemized deductions
- Medical threshhold is 10% (not 7.5%) of AGI
- Home mortgage interest limited to primary residence
- Home equity interest greatly limited
- Investment interest limited: recompute investment Y
- Oil Depletion recalculated
- No exclusion for "private activity" muni bond interest
Change the timing of other items
- Longer lives and slower asset depreciation: so basis and gain on sale of property differs
- Alternative operating loss carryover calculations
- Incentive Stock Options: the bargain is taxed on option exercise, not when stock sold
- various other amortization differences
Replace personal exemptions
An allowance of $33,750 S and $45,000 MFJ (plus in 2002-04 a short-term increase). This supposedly meant that average taxpayers wouldn't worry about AMT.
But: this exemption itself is phased out. When AMTI before exemption exceeds $112.5K S, 150K MFJ, decrease exemption $1 for every $4 AMTI. What's the *effective* marginal rate?
The AMT rates
Originally 20% in 1986. Increased for individuals in 1993 to 26% on 1st 175K, 28% excess
Still get capital gains maximum tax of 20%, tho (Added in 1997) BUT: capital gains can hurt on the exemption phaseout. Income up $100 means exemption down by $25.
AMT Tax Credits are limited
Only get the "alternate minimum foreign tax credit"
Other credits are deferred or lost, except for a temporary fix for some of the family/child credits.
THE BIG PROBLEM
Regular tax brackets and exemptions are inflation indexed. AMT isn't. Recent tax laws increased use of credits that don't reduce AMT. Number of AMT taxpayers is poised to explode in @ 2004-2006, and eliminating AMT is extremely costly
Tax planning for the AMT
Who pays it now?
1998: 853,000 individual returns, $5.0 bb
Doubled from 1996 to 1998
High income (because of 33/45 K exclusion, tend to be over $100K). 3/4th's of total amt liability is on returns w/ AGI over $200K.
Strangely, exposure decreases over $1mm /yr -- the 38.6% regular rate finally dominates at this level
pattern of deductions that are preferences - eg. State tax, or ISO recipients w/o a *lot* of tax planning
example:
- mfj wages 160K, CA tax 15K, Misc itemized 40K
- regular taxbl Y roughly $103K for $23K tax
- AMTI is 160 - 45 exemption * 26% = $30.5K
How to plan: the concept of "crossover"
Tax planning aims for the crossover point. If AMT > regular tax, deductions are wasted
Rocket science: the AMT credit
Sec. 53: a recursive definition
"the minimum tax credit for any taxable year is the excess (if any) of--
(1) the adjusted net minimum tax imposed for all prior taxable years beginning after 1986, over
(2) the amount allowable as a credit under subsection (a) for such prior taxable years."
So: Xt=sum(ANMT1...ANMTt-1) - sum(X1...Xt-1)
"Adjusted net minimum tax" means AMT - (AMT due to preference -- non-timing -- items alone)
Policy: so Tp won't be hurt as timing items reverse
So: AMT due just to timing items in year 1, to the extent it exceeds regular tax, can reduce regular tax in year 2, but not below (the greater of) year 2's AMT or year 2's AMT not counting timing items
"If you don't understand it, you're right."
notes and format (c) 2001-02 Robert H. Daniels