Individual Income and Employment Taxes

Question 1

True or False: Social security taxes for employees are paid 50% by the employer and 50% by the employee.

Answer 1

True.

Question 2

True of False: A) $1 of itemized deduction is more beneficial to a taxpayer than $1 of deductions in arriving at AGI.

Answer 2

False. Reducing AGI $ 1 benefits taxpayers on more than the bottom line. Additionally, the taxpayer may benefit from standard deduction instead of the itemized deduction.

Question 3

True or False: Social security taxes are applicable to 100% of an employee’s wages.

Answer 3

False. Social security taxes are only applicable to an individual’s wages up to a certain amount (i.e., $113,700 in 2013).

Question 4

Medicare taxes are an example of a flat tax, as opposed to a progressive or regressive tax.

Answer 4

False. Starting in 2013, the Medicare tax is progressive. The so-called Obamacare legislation imposes an additional 0.9% tax on wages over $200,000 for a single individual and $250,000 for married taxpayers filing a joint return. Note the $200,000 and $250,000 thresholds are not indexed for inflation, and the entire 0.9% is paid by the employee, not the employer.

Question 5

True or False: The AMT is the excess of the Tentative Minimum Tax over the Regular Tax.

Answer 5

True: The Alternative Minimum Tax (AMT) is the additional tax paid to bring the regularly calculated income tax into equity with the Tentative Minimum Tax (TMT).

Question 6

True or False: Refundable tax credits can provide significant tax benefits to taxpayers with low incomes.

Answer 6

True. Refundable tax credits provide a source of welfare for low income taxpayers.

Question 7

True or False: The foreign tax credit is intended to minimize the chance of a taxpayer being subject to double taxation.

Answer 7

True.

Question 8

True or False: AGI is a concept applicable to both individual income tax and corporate income tax

Answer 8

False. AGI is only applicable for individual income taxes.

Question 9

True or False: Long-term capital gains are taxed at a lower rate than ordinary income

Answer 9

True

Question 10

True or False: Medicare taxes are applicable to 100% of an employee’s wages and 50% of a self-employed person’s self-employment income.

Answer 10

False. 100% of self-employment income is subject to self-employment tax, not 50%.

Question 11

Assume a cash method individual taxpayer is in the 39.6% tax bracket and is deciding whether to pay a $100,000 Pennsylvania estimated tax payment in December 2013 or January 2014. Further assume their accountant tells them that their 2013 federal income tax liability will be $1,000,000 if the individual makes the $100,000 payment in December 2013 and $1,038,000 if they wait to make the payment in 2014.

Given these facts, what is the individual’s marginal tax rate with respect to the potential $100,000 deduction for the Pennsylvania estimated tax payment?

Answer 11

Marginal Tax Rate = $38,000/$100,000 = 38%.

This problem attempts to illustrate that in order to determine the true marginal tax rate one needs to do a with and without calculation. The individual’s income tax liability without the $100,000 tax deduction is $1,038,000 while the tax liability with the deduction is $1,000,000. The $38,000 difference is the incremental or marginal impact of the $100,000 tax deduction. Thus, the marginal tax rate = $38,000/$100,000 = 38%.

Question 12

Explain what a marriage penalty is.

Answer 12

A marriage penalty is when a married couple pays more tax as a result of filing a joint tax return than the combined tax they would pay if they were single.

Question 13

If a couple is planning to get married in either December 2013 or January 2014 and they are expecting to receive a marriage bonus, when should they get married (assuming tax is driving the marriage date)?

Answer 13

December 2013. A marriage bonus is when a married couple pays less tax as a result of filing a joint tax return than the combined tax they would pay if they were single.

Question 14

True or False: Since capital losses can be carried forward indefinitely, individuals generally should not worry about when they recognize a large capital loss.

Answer 14

False.

Since individual capital losses can only be carried forward (i.e., they cannot be carried back), a large capital loss could take years or decades to recognize or possibly never be utilized. For example, if someone who is 60 years old recognizes a $300,000 capital loss and has no anticipated future capital gains, at $3,000 per year, it would take 100 years to fully utilize the $300,000 capital loss.

If such an individual had recognized a substantial capital gain previously, it may have been better to recognize the capital loss at that point in time. Alternatively, the individual could have attempted to delay the recognition of the capital gain until the capital loss was recognized. It should be noted, in some cases it may be impossible to avoid the recognition of a large capital loss without any current or future offsetting capital gains, but if possible, the scenario should be avoided.

Question 15

True or False: A portion of the AMT is creditable, but the calculation is complicated.

Answer 15

True.

Question 16

True or False: The AMT is a separate tax calculation with its own set of rules.

Answer 16

True. The AMT recalculates income by eliminating several exemptions and deductions.

Question 17

True or False: A married couple with no children living in a state with no income taxes is more likely to be subject to the AMT than a couple with 5 children living in New York State.

Answer 17

False. Since they are not deductible for the AMT, two of the main causes of individuals being subject to the AMT are the following:

• Personal exemptions
• State taxes

Thus, a married couple with no children is less likely to be subject to the AMT than a couple with 5 children. In addition, since NY State is generally viewed as a high-tax state a couple living in such state will be more likely to be subject to the AMT than a couple living in a state with no income tax.

Question 18

In 2016 the maximum tax rate on capital gains is 23.8% (i.e., 20% maximum capital gains + 3.8% net investment income tax for individuals with income over certain levels).

Answer 18

True

Question 19

Assume a married couple

1. files their return as married filing jointly and therefore has a $12,400 standard deduction;
2. has $100,000 of AGI; and
3. is in the 25% tax bracket and is not impacted by the phase-out of itemized deductions or the individual AMT.

Also assume the couple has paid the following amounts that qualify as itemized deductions before considering various AGI limitations:

• Medical and dental - $11,000
• State and local taxes - 3,400
• Mortgage interest - 9,000
• Charitable contributions - 1,000
• Miscellaneous itemized deductions - 1,000
• Total Itemized Deductions before AGI limitations - $25,400

Given these assumptions, how much incremental tax benefit (i.e., reduction in tax liability) would you expect the couple to obtain from the $25,400 of itemized tax deductions vs. claiming the $12,400 standard deduction?

As you answer this question, please assume medical and dental expenses for individuals are only deductible to the extent they exceed 10% of AGI and miscellaneous itemized deductions are only deductible to the extent they exceed 2% of AGI.

Said differently, the marginal tax benefit of claiming itemized deductions should be assumed to be at a 25% rate.

Answer 19

Tax Benefit from the $25,400 of itemized deductions = $2,000 x 25% = $500.

Before AGI Limitation - After AGI Limitation

• Medical and dental - $11,000 - $1,000
• State and local taxes - 3,400 - 3,400
• Mortgage interest - 9,000 - 9,000
• Charitable contributions - 1,000 - 1,000
• Miscellaneous itemized deductions - 1,000 -0-
• Total Itemized Deductions before AGI limitations - $25,400 - $14,400

Although the individual has $14,400 of itemized deductions after the AGI limitation, these deductions only provide tax benefit to the extent they exceed the $12,400 standard deduction. Thus, the tax benefit equals ($14,400 - $12,400) x 25% tax rate = $2,000 x the 25% marginal tax rate = $500.

Question 20

True or False: From a tax perspective, businesses generally prefer to classify individuals as an employee rather than an independent contractor.

Answer 20

False. Businesses generally prefer to classify individuals as independent contractors to avoid paying both the employee and employer share of employment taxes.

Question 21

True or False: AGI is used extensively for determining whether tax benefits are allowed or disallowed.

Answer 21

True. AGI is used extensively to determine whether an individual is eligible for certain tax benefits. For example, tax benefits are often phased-out as AGI increases. In addition, certain deductions (e.g., medical and dental expenses) are only allowed to the extent they exceed a certain percentage of AGI.

Question 22

If an individual has $30,000 of capital losses for the year and no capital gains, the individual can only deduct $3,000 of capital losses.

Answer 22

IRC 1212(b) provides that capital losses can only be carried forward. They cannot be carried back. For example, if an individual recognizes $30,000 of capital gain in year 1 and $30,000 of capital loss in year 2, the individual will only be able to recognize $3,000 of net capital loss in year 2 and will need to carryforward the unused $27,000 capital loss to subsequent years.

Question 23

True or False: Tax deductions are generally more valuable than tax credits.

Answer 23

False. Since tax credits generally reduce a taxpayer’s tax liability “dollar for dollar”, they are more beneficial than tax deductions that only reduce the tax liability by the amount of the tax deduction multiplied by the marginal tax rate.

Question 24

True or False: Two major refundable credits are the Earned Income Tax Credit and Child Tax Credit.

Answer 24

True. The Earned Income Tax Credit (EITC) and Child Tax Credit (CTC) provide low income workers and families with children monitary assistance.

Question 25

Assume an individual taxpayer has $300,000 of AGI and is in the 35% tax bracket. Also assume the standard deduction is $6,100, but the individual has paid the following amounts that qualify as itemized deductions before considering various AGI limitations:

• Medical and dental - $30,000
• State and local taxes - 10,100
• Mortgage interest - 10,000
• Charitable contributions -6,000
• Miscellaneous itemized deductions - 5,000
• Total Itemized Deductions before AGI limitations - $61,100

Given these assumptions, how much incremental tax benefit (i.e., reduction in tax liability) would you expect the individual to obtain from the $61,100 of itemized tax deductions vs. claiming the $6,100 standard deduction?

As you answer this question, please assume medical and dental expenses for individuals are only deductible to the extent they exceed 10% of AGI and miscellaneous itemized deductions are only deductible to the extent they exceed 2% of AGI.

Answer 25

Tax Benefit from the $61,100 of itemized deductions = $20,000 x 35% = $7,000.

• Before AGI Limitation - After AGI Limitation
• Medical and dental - $30,000 $ -0-
• State and local taxes - 10,100 - 10,100
• Mortgage interest - 10,000 - 10,000
• Charitable contributions - 6,000 - 6,000
• Miscellaneous itemized deductions - 5,000 -0-
• Total Itemized Deductions before AGI limitations - $61,100 - $26,100

Although the individual has $26,100 of itemized deductions after the AGI limitation, these deductions only provide tax benefit to the extent they exceed the $6,100 standard deduction. Thus, the tax benefit equals $26,100 - $6,100 = $20,000 x the 35% tax rate = $7,000.

Question 26

True or False: Excess capital losses can be carried back 2 years.

Answer 26

False. Individual capital losses can only be carried forward. They cannot be carried back.

Question 27

Assume you are an owner of a small business and you

1. earn approximately $300,000 per year, and
2. have a choice between organizing as an S corporation or a sole proprietorship.

If you are willing to accept tax risk and your goal is to reduce federal employment taxes, what tax planning might you consider and briefly explain why?

Answer 27

You should consider organizing as an S corporation to reduce the amount of Medicare tax you pay.

If you organize as a sole proprietorship, 100% of your earnings (i.e., $300,000) will be subject to the Medicare tax. However, if you organize as an S corporation and pay yourself a salary that is less than $300,000, you can potentially avoid Medicare tax on the portion of your income not paid in salary.

For example, if you pay yourself a $200,000 salary, you and your S corporation should only pay Medicare tax on $200,000 of wages whereas as a sole proprietor you would pay self-employment tax on the entire $300,000 of income. The IRS could challenge the S corporation by arguing the salary to the shareholder-employee should have been $300,000. However, the IRS has not had much success arguing cases where a reasonable amount of salary has been paid to the shareholder-employee of an S corporation.

Finally, the S corporation strategy may also be successful at reducing social security taxes if the amount of wages paid to the shareholder-employee is less than the social security cap (i.e., $113,700 in 2013). However, the lower salary paid may result in more scrutiny from the IRS.

Question 28

True or False: Since individuals can only deduct $3,000 of net capital losses per year, capital losses can be a MAJOR problem if a taxpayer does not have realized capital gains to offset them in the year the capital losses are recognized.

Answer 28

True.

Question 29

True or False: The tax rate on capital gains is 20% + 3.8% net investment income tax.

Answer 29

False. The capital gains rate depends upon the taxpayer’s ordinary income tax bracket.

Question 30

True or False: Individual capital loss carryovers can only be carried forward 5 years.

Answer 30

False. Capital losses can be carried forward indefinitely.

Question 31

True or False: Employers are required to withhold from an employee’s salary an amount based upon

• their income level and
• expected exemptions claimed on an IRS Form W-4, Employee’s Withholding Allowance Certificate.

Answer 31

True.

Question 32

True or False: If a calendar year individual needs to pay estimated income taxes, the payment due dates are April 15, June 15, September 15, and January 15 of the following year. Note these dates can be extended if they fall on a weekend or holiday.

Answer 32

True.