Personal Income Tax

What Constitutes Gross Income?

The definition of gross income is important. Gross income is:

  • used to determine whether a tax return must be filed
  • the starting point for figuring your tax

Gross income includes all receipts in the form of money, goods, property, or services that are not specifically exempt from tax. Gross income includes:

  • Wages and tips
  • certain fringe benefits
  • interest and dividends
  • rents and royalties
  • retirement account distributions
  • most prizes and awards
  • unemployment compensation

Gross income also includes:

  • a partner’s share of the income of a partnership
  • a shareholder’s share of the income of an “S” corporation.

Other taxable forms of income include:

  • Beneficiaries of estates and of most “simple” trusts receiving income earned by assets held by the estate or trust must include that in their gross income.
  • A portion of Social Security benefits may be taxable depending on whether a taxpayer is single or married and the amount of the taxpayer’s other income.
  • The receipt of a state income tax refund may be taxable to the extent that the refund tax was deducted on a federal income tax return for a previous year and reduced that year’s tax.

Certain types of income are specifically exempt from tax, such as:

  • gifts and inheritances
  • life insurance proceeds
  • interest on municipal bonds
  • child support payments

However, in order to be exempt from tax, the payment must satisfy all statutory requirements for the exemption.

Capital Gains and Losses on the Sale of Property

Gains earned from the sale of property are taxable unless there is a statutory exception.

  • If the gain is “short term,” it is taxed like other income.
  • “Long term” gains from the sale of capital assets are taxed at lower rates.
  • Losses from the sale of property held for personal use are not deductible.
  • Losses from the sale or exchange of investment property may or may not be deductible, depending upon the type and use of the property and the amount of the loss.

The rules in this area are exceedingly complex. The complexity increased with the passage of the Taxpayer Relief Act of 1997.

Most property you own and use for personal purposes, pleasure, or investment is considered a capital asset. Your house, furniture, car, stocks, and bonds are capital assets. Certain property that you create and certain property used in a trade or business is not considered a capital asset.

Gain from the sale or other disposition of property is calculated by subtracting what is known as the adjusted basis of property from the amount realized.

  • The amount realized is equal to the sum of money received plus the fair market value of other property received.
  • The amount realized is increased if the buyer becomes responsible for any debt you owe to a third party.

Tax basis is equal to your cost for buying the property. If you borrow money to buy property, the amount borrowed qualifies as part of your basis.

  • The tax basis may need to be adjusted while you own the property.
  • The tax basis is increased for additional investments or improvements to the property.
  • Tax basis is decreased by depreciation and non-taxable withdrawals. The adjusted basis of the property at the time of sale is used to calculate gain or loss.

Tax on the Sale of a Principal Residence

The Taxpayer Relief Act of 1997 enacted a new exclusion for gain from the sale of a principal residence. If you have owned and lived in a home, which you use as your primary residence, for two of the last five years before the sale of the property, you may exclude $250,000 of the gain. Married taxpayers qualifying for the exclusion may exclude $500,000 of the gain if a joint tax return is filed. The exclusion may be used once every two years. Gain that cannot be excluded is taxed currently.

Personal Deductions

Deductions are certain expenses that can be subtracted from gross income and thus help to reduce the amount of taxes you pay. There are two kinds of deductions.

“Above-the-line” deductions are available to all taxpayers even if they are not eligible to itemize deductions. Above-the-line deductions include:

  • expenses incurred in a trade or business
  • alimony payments
  • deductible contributions to Individual Retirement Accounts and Medical Savings Accounts
  • penalties imposed by banks for interest

Self-employed individuals may also deduct a portion of their:

  • payroll taxes
  • health insurance premiums
  • contributions to retirement accounts

The term “adjusted gross income” (AGI) is used to denote the amount of your gross income after subtracting above-the-line deductions.

Interest on Higher Education Loans

Beginning in 1998, you may be entitled to deduct interest paid on money borrowed to pay for post-secondary educational institutions and certain vocational schools. You do not need to itemize your deductions in order to deduct this interest. There are a number of restrictions on the deduction of this interest.

  • The maximum deductible amount is $1,000 in 1998. This ceiling increases each year through 2001 when the maximum deduction becomes $2,500.
  • The deduction is only available to taxpayers at moderate-income levels. The deduction begins to phase out and then becomes unavailable when adjusted gross income exceeds $40,000 for individuals and $60,000 for married taxpayers.
  • Married individuals must file jointly in order to take this deduction.

Individual Retirement Accounts (IRA)

A deductible contribution to an IRA will reduce your adjusted gross income. The general limit for annual contributions is the lower of your earned income or $2,000. However, many married homemakers with no earned income may still contribute $2,000 to an IRA. If you or your spouse participate in an employer-sponsored retirement plan, the deduction may be phased out if your adjusted gross income is too high.

IRA earnings accumulate on a tax-deferred basis. The income is only taxed when funds are withdrawn from the account. Generally, distributions cannot be made to the taxpayer until age 59 ½, but must begin at age 70 ½. Early distributions are subject to tax and a 10% penalty. No penalty is imposed under certain circumstances:

  • if the distribution occurs because of death or disability
  • if it constitutes a series of substantially equal periodic payments
  • if the funds up to $10,000 are used to acquire a “first” home for you or your children or grandchildren
  • to pay post-secondary educational expenses for you, your spouse, child, or grandchild

Roth Individual Retirement Accounts (Roth IRAs)

Beginning in 1998, an IRA may be designated as a “Roth IRA.” A Roth IRA is treated like an ordinary IRA except that the contributions cannot be deducted from current income. The benefit of a Roth IRA is that the earnings will never be subject to tax if:

  • distributed five or more years after the tax year of the contribution and after you are age 59 ½,
  • on account of your death or disability
  • to pay for “qualified first-time homebuyer expenses”

Roth IRAs are only available if your annual gross income is:

  • less than $110,000 if single
  • less than $160,000 if married filing jointly

The deduction begins to be phased out if your income is:

  • more than $95,000 if single
  • more than $150,000 if married

Married taxpayers filing separate tax returns cannot contribute to a Roth IRA.

Ordinary IRAs may be converted or rolled into a Roth IRA if:

  • your adjusted gross income does not exceed $100,000
  • you are not married filing a separate return

The rollover amount is subject to income tax but not the 10% penalty. If the rollover occurs in 1998 the income may be reported over a four-year period beginning with the year of the rollover.

Individual Retirement Accounts for Education Expenses

Beginning in 1998, you may be able to make annual contributions of up to $500 to a new type of Individual Retirement Account to cover higher education costs of each of your children in the future.

  • A separate IRA may be set up for each child. The child must be designated as the beneficiary of their own IRA.
  • Contributions may be made until the child reaches the age of 18.
  • Although the contributions are not deductible, the earnings accumulate tax free as long as the IRA is actually used to pay the child’s post-secondary education expenses.

The ability to contribute to an Education IRA begins to phase out for:

  • single filers with modified adjusted gross income of $95,000
  • joint filers with adjusted gross income of $150,000

Moving Expenses

If you are starting a new job that is not your first job and you are required to move to a distant location, you may be able to deduct your reasonable moving expenses. Deductible expenses include:

  • the costs of moving household goods and personal effects
  • your family’s travel costs to the new home

The moving expense deduction is an above-the-line deduction.

Itemized Deductions

Deductions that are not “above-the-line” are only available if you are qualified to itemize your deductions. If your itemized deductions are less than a certain amount, you are entitled instead to a “standard deduction.” The amount of the standard deduction is based on your filing status. The standard deduction changes each year based upon an inflation adjustment.

Itemized deductions consist of:

  • medical expenses
  • taxes
  • interest paid on loans for certain purposes
  • charitable contributions
  • casualty and theft losses
  • tax preparation fees
  • unreimbursed business expenses related to one’s employment

The itemized deductions of high-income taxpayers may be reduced based upon the amount of their income and their filing status.

Medical Expenses

Deductible medical expenses include:

  • doctor and dental bills
  • hospital costs
  • prescription drugs and insulin
  • medical aids such as eyeglasses, hearing aids, and braces
  • insurance premiums for medical and dental care

Medical expenses are only deductible if they have not been reimbursed by health insurance and if the total expense for the year exceeds 7.5% of your adjusted gross income.

Deductible Taxes

You may deduct:

  • state, local, and foreign income taxes
  • real estate taxes
  • personal property taxes
  • certain other taxes

You may not deduct:

  • federal income, estate, gift, or excise taxes
  • Social Security taxes
  • customs duties
  • certain state and local taxes such as sales tax or the tax on gasoline, car inspection fees, or assessments for improvements to your property

Interest Expense

The interest paid on most debt is not deductible. You may deduct interest for:

  • interest paid on student loans (an above-the-line deduction)
  • borrowing for investment purposes but only to the extent that your investment income exceeds your investment expense
  • qualifying home mortgage loansYour main home or a second home must legally secure the home mortgage loan. The home may be a condominium or cooperative. It can be a mobile home, boat, or similar property as long as it has basic living accommodations (sleeping space, toilet and cooking facilities). There are additional limitations based upon the amount of the loan and whether the loan was taken out to buy, build, or improve the property.

Charitable Contributions

You may deduct contributions or gifts to:

  • organizations that are religious, charitable, educational, scientific or literary in purpose
  • organizations to prevent cruelty to children or animals

Other deductions include:

  • If you do volunteer work for a charitable organization, you are entitled to a deduction for your commuting expenses.
  • If you make a gift of $250 or more, you must have a statement from the charity by the time you file your tax return in order to deduct the contribution. You will not be entitled to the deduction if you do not file your return on time.
  • You may also deduct non-cash gifts such as used clothing or furniture. The deduction is based upon the fair market value of the property. If the property you contribute is worth more than $5,000 you may need to obtain an appraisal. IRS Publication 526 provides further information on charitable deductions.

Casualty and Theft Losses

Casualty and theft losses are deductible if the amount of the loss that has not been covered by insurance exceeds a certain percentage of your income. You may be able to deduct part or all of each loss caused by theft, vandalism, fire, storm or similar causes, as well as car, boat, and other accidents.

Miscellaneous Itemized Deductions

Other itemized deductions include ordinary and necessary expenditures:

  • for the production or collection of income
  • for the management, conservation, or maintenance of property held for the production of income
  • for the determination, collection, or refund of any tax

Examples include:

  • fees for the preparation of your tax return
  • certain investment and legal expenses
  • job-hunting expenses and job-related expenses such as union dues

These expenses are only deductible to the extent they cumulatively exceed 2% of your adjusted gross income. You may not deduct:

  • political contributions or personal legal expenses
  • commuting costs or rental payments for your home
  • food or clothing costs

Tax Credits

A tax credit reduces your tax dollar-for-dollar, so it is more valuable than a deduction, which merely reduces the amount of income subject to your tax rate. You may be able to take a credit against your tax if you have:

  • children
  • child or dependent care expenses
  • adoption expenses
  • if you are elderly or disabled
  • if your earned income is below a certain threshold
  • if you paid foreign taxes

The rules and restrictions for each type of credit are quite complicated. You will need to fill out an additional form or schedule for each type of credit you claim.

Child Tax Credit

The Taxpayer Relief Act of 1997 created a new tax credit for children. Starting in 1998, a $400 credit is available for each qualifying child. The credit increases to $500 per child in 1999. In order to qualify for the credit a child must be a U.S. citizen who can be claimed as a dependent and is less than 17 years old. The definition of a child includes a foster child who lives with you for the entire year, as well as a stepchild or grandchild.

The child tax credit is not available to high-income taxpayers. The credit begins to phase out if your adjusted gross income exceeds certain fixed amounts based upon your filing status:

  • $110,000 if filing jointly
  • $55,000 for married individuals filing separately
  • $75,000 for singles and heads of household

Low-income taxpayers with three or more children may be entitled to the credit even though it exceeds their tax. The rules in this regard are too complex to be summarized here.

Child and Dependent Care Credit

The child tax credit should not be confused with the child and dependent care credit. This credit is for services provided to care for:

  • children who are less than 13 years old
  • dependents who are incapable of caring for themselves so that a taxpayer can search for a job, be employed, or be self-employed outside of the house

In general, the credit is equal to 30% of expenses for your child or dependent care. The percentage is reduced gradually to 20% when your adjusted gross income reaches $30,000. Creditable work-related expenses may not exceed:

  • $2,400 per year for one child
  • $4,800 for two or more children

Education Credits

The Taxpayer Relief Act of 1997 also created the HOPE Scholarship Credit and the Lifetime Learning Credit.

  • The HOPE Scholarship Credit provides a maximum tax credit of $1,500 per student for tuition payments during each of the first two years of post-secondary education. It does not cover room, board, or books. The credit is equal to 100% of the first $1,000 of qualified expenses and 50% of the next $1,000. This credit may be taken twice for each eligible student.
  • The Lifetime Learning Credit is similar in many respects to the HOPE Scholarship Credit. However, the Lifetime Learning Credit is equal to 20% of the cost of qualified tuition and related expenses. It covers courses to acquire or improve job skills. The maximum credit is $1,000 per taxpaying family beginning with expenses paid after June 30, 1998. The maximum credit increases to $2,000 in 2003.

Both the HOPE Scholarship Credit and the Lifetime Learning Credit begin to phase out if your adjusted gross income:

  • exceeds $80,000 if married filing jointly
  • $75,000 for single taxpayers and heads of household

Married individuals filing separately do not qualify for these credits. Additionally, you cannot claim the Lifetime Learning Credit for any expenses for which you elect to utilize the HOPE Scholarship Credit.

Who Must File an Individual Income Tax Return?

If you are a citizen or resident of the United States, you must file a federal income tax return if you meet the filing requirements which are based upon your age, filing status (single, married or head of household), and amount of gross income. Form 1040-EZ is the simplest form, Form 1040A is somewhat longer. Most taxpayers use one of these two forms. You must use Form 1040 if:

  • your taxable income is greater than $50,000
  • you itemize deductions
  • if for some other reason you do not qualify to use these simpler forms\

If you are neither a citizen nor resident of the United States but you earned income in the United States, you may have to file a non-resident income tax return (Form 1040NR or Form 1040NR-EZ). Reference IRS Publication 519, U.S. Tax Guide for Aliens, to find out if the income tax laws apply to you and which forms need to be filed.

Residents of most states must also file state income tax returns if their income exceeds the state’s filing threshold. Non-residents may also be required to file tax returns in states where they work or earn money. Most states, but not all, follow the federal income tax in determining the taxable base. Each state has its own rules and regulations which are beyond the scope of this summary.

Tax Audits and Appeals

The Internal Revenue Service (IRS) audits tax returns in order to encourage accurate and timely filing of returns as well as to obtain additional revenue. Less than one percent of federal income tax returns are selected for audit. A sophisticated procedure is used to select the tax returns to review. That means that returns of high-income individuals, those with substantial income from a business or profession, and large corporations are more likely to be audited than other taxpayers.

Audits are conducted in three distinct ways:

  • through the mail
  • in an IRS office
  • at a taxpayer’s home or business

Once the audit has been completed, the tax examiner either accepts the return as filed or proposes that the tax liability be adjusted. If a taxpayer does not agree with the auditor’s findings, the IRS sends a formal notice of adjustment.

A taxpayer can appeal an auditor’s findings by submitting a written protest to the IRS Appeals Office. If a taxpayer does nothing, then the IRS will “assess” the tax. The assessment may be challenged by the taxpayer in the U.S. Tax Court before paying the tax.

A taxpayer may also pay the tax and file a Claim for Refund with the IRS. If the IRS denies the Claim, the taxpayer may file a refund suit in federal district court or in the U.S. Court of Claims.

Tax Collection

A tax is assessed when either:

  • a tax return is filed
  • when an audit results in a tax deficiency that is not successfully contested in the U.S. Tax Court

When a taxpayer has failed to pay an assessed tax after being given 10 days notice to do so, all of a taxpayer’s property is automatically subject to a lien in favor of the government.

Once a lien exists, the IRS can notify a taxpayer of its intention to levy. After a period of 30 days, the IRS may levy upon, seize, and sell all of the taxpayer’s property. This would include the seizure of a taxpayer’s home and bank accounts. The IRS can also seize, by way of garnishment, a taxpayer’s current and future salary and wages.

A taxpayer has few alternatives to avoid collection activity. If the tax cannot be paid in full, a taxpayer can either:

  • try to enter into an installment arrangement with the IRS
  • submit an offer to settle with the IRS for less than the full amount that is due

A so-called “Offer in Compromise” is a lengthy procedure to reduce the amount owed. A taxpayer must show that it is unlikely that the government would be able to successfully collect the debt, or that it is likely that the tax should never have been assessed.

Interest and Penalties

As a general rule, interest is charged if the full amount of tax is not paid by the due date of a return.

  • An interest-like penalty may also be charged where estimated taxes should have been paid throughout the year.
  • Interest is also paid to taxpayers who overpay their taxes.
  • Interest is also charged on the late payment of penalties or interest.

The interest rate changes every three months. Interest is assessed, collected, and paid in the same manner as tax.

The IRS can impose numerous civil and criminal penalties.

Civil penalties are normally based upon a percentage of the unpaid or late paid tax. Some reasons for imposing civil penalties include:

  • filing or paying a tax return late
  • negligently or fraudulently understating one’s tax liability
  • filing a frivolous tax return
  • failing to deposit tax withholdings

Civil penalties are generally assessed, collected, and paid in the same manner as tax.

Criminal penalties can result in imposing large fines and/or imprisonment. Reasons for imposing criminal penalties include:

  • filing a false or fraudulent return
  • evading tax
  • failing to file a return or pay a tax
  • making false statements under oath

The U.S. Department of Justice, not the IRS, prosecutes criminal cases. Taxpayers are entitled to the same constitutional guaranties and rights as are other criminal defendants. Because criminal tax cases involve entirely different procedures, a taxpayer charged with a criminal tax offense, whether or not convicted, may also be liable for a civil penalty.