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Federal Income Tax
Note: To access the Federal Gift Tax, Federal Estate Tax, or Generation-Skipping Transfer Tax, click on "Estate Planning" on the AMO home screen or in the Contents window at the left side of your screen. Then click open "Federal Gift and Estate Tax" in the Contents display to see your menu options for accessing the federal transfer tax material.
Gross Income
The tax which generates the greatest amount of revenue for the U.S. government is the federal income tax. For a taxpayer to calculate his or her federal income tax liability, determining gross income is the first step.
Gross income is defined by IRC Sec. 61 as all income from whatever source derived. Although gross income is very broadly defined, it does not include return of capital (for example, repayment of the principal of a loan). Nor does it include interest from certain state or local ("municipal") bonds under certain circumstances (but capital gain on the sale of these obligations is taxable). It does not include contributions to or earnings on certain retirement plans, or increases in the cash value of life insurance or annuity contracts so long as the funds remain in the plan or contract and are not withdrawn.
Typically, gross income takes the form of wages, salaries, commissions, fees, tips, earnings from a business or trade, gain from sale or exchange of property, interest, dividends, rents, and royalties. Payments from Social Security, retirement plans, and Individual Retirement Accounts (IRAs) are subject to special rules.
Exclusions from Gross Income
Certain types of income are specifically excluded from the definition of gross income. Such exclusions from gross income include gifts, bequests, some scholarships and fellowships, Workers Compensation payments, most life insurance death benefits, payments under medical insurance policies, "qualified distributions" under Roth IRAs and Coverdell Education Savings Accounts, Social Security benefits for many recipients, and a number of other special categories of income.
Adjustments to Gross Income
Gross income is reduced by adjustments, deductions, and exemptions before a rate of tax is applied to the residue, taxable income. Adjustments are subtracted from gross income in order to arrive at adjusted gross income (AGI). These adjustments include traditional Individual Retirement Account (IRA) contributions (if deductible), certain moving expenses, a college tuition deduction, 50 percent of self-employment tax, and a certain percent of self-employed health insurance premiums, as well as self-employed retirement plan contributions, penalties on the early withdrawal of savings, and alimony paid.
Itemized and Standard Deductions
Deductions may be itemized, or the standard deduction may be taken. The standard deduction, the amount of which is adjusted yearly, may be taken by any taxpayer who chooses not to itemize deductions. The amount varies with the taxpayer’s filing status. Taxpayers age 65 and above receive an additional standard deduction, as do taxpayers who are blind.
For taxpayers who have substantial deductible expenditures, itemizing deductions will save more taxes than will taking the standard deduction. Itemized deductions include:
• medical and dental expenses
• certain personal taxes
• investment interest
• qualified residence (mortgage) interest
• gifts to charity
• casualty and theft losses
• unreimbursed employee expenses, and
• miscellaneous deductions.
These deductions are subject to a variety of restrictions and limitations. Medical and dental expenses, for example, are not deductible except to the extent that, in the aggregate, they exceed a "floor" of 7.5% of adjusted gross income.
Personal taxes paid which may be deducted include state and local income taxes, real estate taxes, personal property taxes, and certain other taxes. Unlike the medical and dental expense deductions, no "floor" applies to personal taxes.
Investment interest generally may be deducted, but only to the extent of investment income. IRC Sec. 212 provides that individuals may deduct all the ordinary and necessary expenses paid or incurred during the taxable year--
• for the production or collection of income,
• for the management, conservation, or maintenance of property held for the production of income, or
• in connection with the determination, collection, or refund of any tax.
Investment expenses are "miscellaneous itemized deductions" and are therefore deductible only to the extent they exceed the 2% of AGI floor on such deductions.
Expenses attributable to the production of tax-exempt income are generally nondeductible.
Home mortgage interest and points may also be deducted, subject to certain limitations. Neither of these deductions are subject to a percentage "floor."
Charitable contributions are deductible, subject to percentage-of-AGI limitations and other restrictions, and to substantiation and appraisal requirements. For larger gifts, contributions in excess of the current year’s deductibility limits may be carried forward and deducted for up to five years.
Casualty and theft losses are generally not deductible except to the extent that each loss exceeds $100 and, in the aggregate, they exceed 10% of the taxpayer’s AGI.
Unreimbursed employee business expenses, together with most other miscellaneous deductions, are not deductible except to the extent that they exceed 2% of AGI.
Personally paid life insurance and annuity premiums are not a deductible expense; however, deductible contributions to an Individual Retirement Account or Annuity (IRA) are an adjustment to gross income.
Personal and Dependent Exemptions
Exemptions are of two types: personal exemptions and dependent exemptions. The dollar value of exemptions is adjusted annually. Personal exemptions may be claimed by taxpayers themselves and dependent exemptions may be claimed for children and certain other qualified dependents. A Social Security number must be given for each exemption taken, regardless of the age of the dependent.
Click here for the 2009 personal/dependent exemption amount.
Taxable Income
Adjusted gross income (AGI) less the sum of itemized deductions (or the standard deduction) and personal and dependent exemptions equals taxable income, the tax computation base used to determine the tentative income tax. This is calculated from the tax tables or the rate schedules, and possibly from other applicable forms or worksheets. Once the tax owed has been computed, certain tax credits may be taken against the tax owed.
Capital Gains
Maximum Tax Rate on Long-Term Capital Gains
The maximum tax rate on most net long-term capital gains for individual taxpayers in the 25% or higher federal income tax bracket is 15% with respect to gain on sales occurring on and after May 6, 2003 and before Jan. 1, 2011. For net long-term capital gain realized by such taxpayers before May 6, 2003, the maximum tax rate is 20%.
Individual taxpayers who are in a regular federal income tax bracket of 10% or 15% pay tax on net long-term capital gains at a maximum rate of 5% for gain on sales occurring on and after May 6, 2003 and before Jan. 1, 2011. For net long-term capital gains realized by such taxpayers before May 6, 2003, the maximum tax rate is 10%. For years after 2007,the special 5% long-term capital gains rate for these low bracket taxpayers will drop to zero.
Holding Period
The long-term capital gains tax rates generally apply to gains on the sale of capital assets held for "more than one year." Gain on the sale of a capital asset held for one year or less is "short-term" capital gain.
Short-Term Capital Gains
Net short-term capital gains are taxed at ordinary income rates.
Capital Losses
After capital gains and capital losses are netted against one another, any remaining net capital loss may be used to offset ordinary income up to $3,000 per year. Unused net capital losses retain their character, and may be carried over in unlimited amounts and used against future income until exhausted.
Collectibles
Long-term capital gain from the sale of collectibles (e.g., antiques, artworks, coins) is taxed at a top rate of 28%.
Depreciable Real Estate (Section 1250 Property)
Net long-term capital gain attributable to unrecaptured Section 1250 gain on depreciable real estate is generally taxed at a top rate of 25%. The balance of such gain (over and above the recapture) is taxed at a top rate of 15%, for sales on and after May 6, 2003. (If the property was placed in service before 1987, some ordinary income may be recaptured if accelerated depreciation was taken on the property.)
Sale of a Principal Residence
A seller of any age who has used real property as a principal residence for at least two of the last five years can exclude from gross income up to $250,000 ($500,000 if married filing jointly) of gain realized on a home sale. Further, this provision is reusable every two years. Individuals who cannot meet these requirements are eligible for a reduced exclusion under certain circumstances.
Dividends
Special Tax Rate on Dividends
The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the top federal income tax rate on "qualified dividends" received by individual taxpayers to 15%, the same as the top tax rate on long-term capital gains. For individuals in the 15% or lower tax brackets, the top rate on dividends is only 5%.
Qualified Dividends
Dividends eligible for the special tax rate are those received from domestic corporations and certain qualifying foreign corporations whose stock is traded on a U.S. securities exchange or other established market. The 2003 Act did not define "dividend." However, a dividend is generally a corporate distribution to shareholders, based on their stock holdings, made out of current or accumulated earnings and profits, unless the distribution is specifically treated as a non-dividend by tax law (e.g., as a redemption or liquidation distribution).
Dividends that pass through to individuals from regulated investment companies may be eligible for the reduced tax rate on dividends. Mutual fund dividends will be eligible only to the extent they represent dividends the mutual fund earned on stock, and not on other types of fund earnings such as interest. Mutual funds will report to individual investors the portion of their dividends eligible for the reduced rates.
Ineligible Dividends
The special tax rates do NOT apply to dividends paid by, among other things:
• Mutual insurance companies
• Credit unions, mutual savings banks, savings and loans, and certain other types of financial institutions
• Nonprofit voluntary employee beneficiary associations (VEBAs)
• Employer securities owned by an employee stock ownership plan ( ESOP) to the extent the dividends are deductible under IRC Sec. 404(k)
• Stock purchased with borrowed funds when the dividend was included in investment income for purposes of claiming an investment interest deduction
• Tax-exempt corporations under IRC Sections 501 or 521
• Farmers’ cooperatives
• Foreign personal holding companies
• Foreign investment companies
• Passive foreign investment companies, and
• Stock owned for 60 days or less in the 120-day period beginning 60 days before the ex-dividend date (when the corporation makes final the shareholders who will receive the dividend).
The special tax rates also do NOT apply to:
• Payments received in lieu of dividends when shares are loaned out (this may occur when shares are held in an account with a margin agreement);
• Dividends received in an IRA or qualified retirement plan; or
• Any dividend to the extent the taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property.
It appears that dividends on preferred stock will NOT be eligible for the special tax rate if the issuing corporation follows the common practice of (1) treating the preferred stock as debt on its books, and (2) deducting the "dividends" on such stock as interest.
Effective Date and Sunset
The special tax rates apply to qualified dividends received on and after Jan. 1. 2003, and through Dec. 31, 2010. For individuals in the 15% or lower tax bracket, a zero-percent rate will apply to qualified dividends received after 2007 and before 2011.
The special rates are scheduled to expire for dividends received after 2010.
Planning Issues
In the past, owners of closely held C corporations often tried to take money out of the corporation as (reasonable) compensation rather than dividends, because the corporation could deduct the former but not the latter. And that’s still true. However, compensation can now be taxed to individual owners at federal rates up to 35%, while qualified dividends are taxed at only 15%. Moreover, dividends are not subject to payroll taxes, unlike compensation. On the other hand, retirement plan contributions or benefits may be reduced if dividends are taken instead of compensation. Balancing the tax advantages and disadvantages of dividends vs. compensation has gotten more complicated.
Tax Credits
Tax credits are a direct dollar-for-dollar reduction of the tax owed. Some credits may be taken only to offset taxes, while other credits are "refundable" and will be paid to taxpayers even if they exceed the amount of taxes which are owed. Tax credits include:
• child tax credit
• child and dependent care credit
• credits for the elderly and disabled
• earned income tax credit
• Hope scholarship tax credit
• lifetime learning tax credit
• foreign tax credit, and
• certain other credits.
Previous payments of tax essentially function as tax credits and offset the tax currently due. Such previous payments include:
• federal income tax withheld
• estimated tax payments
• overpayments applied from a previous year’s return
• amounts paid with an extension request
• excess Social Security or Railroad Retirement Tax Act (RRTA) withheld, and
• certain other payments.
Alternative Minimum Tax
Individuals are subject to an alternative minimum tax (AMT) that must be paid in lieu of the regular individual income tax if it produces a higher tax. The AMT tax base is determined by eliminating from taxable income certain itemized deductions and requiring the addition of certain items of preference income. An exemption may be subtracted from this recalculated tax base; the amount depends on filing status. Following are the AMT exemption amounts for 2007 through 2009:
2007
2008
2009
Married filing jointly
$66,250
$69,950
$70,950
Certain surviving spouses
$66,250
69,950
70,950
Single taxpayers
$44,350
46,200
46,700
Heads of households
$44,350
46,200
46,700
Married filing separately
$33,125
34,975
35,475
Trusts and estates
$22,500
22,500
22,500
C corporations
$40,000
40,000
40,000
The exemption amounts are reduced by $.25 for each dollar of AMT taxable income in excess of $150,000 for joint filers, $112,500 for singles and heads of households, and $75,000 for married persons filing separately, trusts and estates. The exemptions are completely phased out at $382,000 for joint filers, $273,500 for singles and heads of households, $191,000 for marrieds filing separately, and $165,000 for trusts and estates.
The individual AMT is calculated as 26% of the first $175,000 of AMT income ($87,500 for married filing separately), plus 28% of AMT income over that amount.
An individual’s AMT tax base, or "alternative minimum taxable income," is the sum of the individual’s adjusted gross income and items of preference income, less itemized deductions recognized for AMT purposes such as charitable contributions, home mortgage and certain other interest, medical expenses over 10% of AGI, casualty losses, gambling losses, and the income in respect of a decedent (IRD) deduction.
Items of preference income include intangible drilling costs, depletion deductions, incentive stock options, certain accelerated depreciation deductions, and certain tax-exempt interest.
C corporations are also subject to an alternative minimum tax (AMT). Congress was concerned that many companies which show a loss or little income for tax purposes are really making substantial profits on which they pay little or no taxes. The alternative minimum tax is an attempt to address this "fairness" problem, and must be paid in lieu of the regular corporate income tax if it exceeds the regular tax.
The corporate alternative minimum tax has been repealed for "small corporations" in tax years beginning in 1998 and later years. A small corporation is generally one whose average annual gross receipts do not exceed $5 million for the three tax years that ended with the first tax year beginning after December 31, 1996. A qualifying small corporation preserves its exemption from the AMT as long as its average annual gross receipts for the preceding three-year period do not exceed $7,500,000.
To compute the AMT, a special tax base is determined by reducing corporate income by certain deductions and by adding back in corporate tax preference items. From this base amount a corporate exemption is subtracted. The income remaining is then taxed at a flat rate of 20%. Corporations are allowed a $40,000 exemption, but the exemption is phased out at $.25 for each dollar of AMT taxable income over $150,000, and is completely phased out at $310,000 of corporate AMT taxable income. The alternative minimum tax owed will be the amount by which the result of this calculation exceeds the corporation’s regular income tax.
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