This is the income tax formula that we introduced earlier. In this module I'll provide an overview of each general section of this formula. Briefly, the income tax formula begins with income that's broadly conceived. That is assumed everything is income unless Congress says it's not. Next are exclusions. Exclusions are income items that, although it's technically income and money in a taxpayer's pocket, Congress has in fact decided not to tax that income. For example, interest earned on municipal bonds is not part of the federal income tax base and thus is excluded. That's the difference between income broadly conceived and exclusions is gross income. Gross income is the income subject to tax. Next, we subtract various deductions or expenses. The first set of deductions are referred to as deductions for adjusted gross income, because they're subtracted from gross income to produce this adjusted gross income subtotal better known as AGI. Next, the taxpayer can subtract a second set of deductions. In fact, they can select to deduct the greater of either itemized deductions, also known as from AGI deductions, or the standard deduction, which is a standard amount that's allotted to each taxpayer based on his or her filing status. After subtracting either itemized deductions or the standard deduction, we next, beginning with tax till 2018, having up to 20 percent deduction for qualified business income. This is certain qualifying income, subject to some limitations generated from flow through entities such as partnerships or S Corporations or from sole proprietorships. Finally, we get to taxable income as the difference between the AGI and the various additional deductions and exemptions. Recall the taxable income is the tax base in the US income tax system. Next, to calculate the tax liability, we use our tax tables in tax-rate schedules. From the tax liability, we can subtract any income taxes that were withheld or prepaid during the year, as well as the various tax credits which are dollar for dollar reductions in the tax liability. The difference between the tax liability and the amount of prepayments and credits claimed during the year will tell us whether or not the taxpayer needs to pay more to cover the entire tax liability because the prepayments or withholdings weren't enough, or if the tax payer prepaid more than the tax liability during the year then he or she will receive a refund. The form 1040 is the main US federal income tax return that's filed with the IRS. It's generally structured according to the formula on the previous slide. It's key sections begin by asking for the taxpayers filing status. That is, how are you filing your tax return? Are you filing as a single person or are you married and filing a joint return with your spouse, or perhaps you fit into another category? Maybe you're married, but you're filing a separate tax return from your spouse. Next, the 1040 asks who else is being claimed on your tax return. Who you claim as your dependents either as qualifying children and or qualifying relatives, may still qualify you for certain tax credits we'll learn about later in the course. Then the 1040 goes through the tax formula, essentially asking what's the taxpayers gross income? Then it asks what's the adjusted gross income? The taxable income and the tax liability and finally, any additional amount owed or re-funded. During the course we'll dive more deeply into each of these sections. Note that although the 1040 is the main tax form, there are a lot of supporting schedules and statements as well. In particular, schedule A reports itemized deductions. Schedule B reports interest and dividends. Schedule C reports income and expenses from a sole proprietorship, that is a single owner business. Schedule D reports capital gains and losses. Schedule E reports supplemental income and losses including from rents and royalties, and schedule F reports farm income and losses. All of this information gets summarized on the form 1040. Let's start at the very beginning of the income tax return formula, highlighted here at gross income. Which includes income broadly conceived and exclusions to that income. IRC Section 61 explains that, "Except as otherwise stated, gross income is all income from whatever source derived." This income includes income from wages, from services, from fees, commissions, benefits, business income, gains from property dealings, interest, rents, dividends, capital gains, and a lot of other items. In fact, this provision also implies that income from illegal activities is also included in gross income as it's something received that isn't cash, but in exchange for services. If my friend pays me with a new watch instead of cash from me to prepare his tax return, I have to report the value of that watch in my gross income. It is includable in calculating the tax base. This gets us to the conceptualization of gross income. The US tax laws use an all-inclusive income concepts. Within this concept, we need to differentiate between two kinds of incomes: realized income and recognized income. We can think of realized income as economic income, a very broad concept. When do you realize economic income? Well, you realize economic income, when you have an exchange of property rights. For example, I own a home. If I bought it for 250,000 and I sell it for 300,000 I have $50,000 in realized income. I've given up my property rights to the house in this transaction, and now I know exactly the size of my income. Generally, all realized income is included in gross income unless it's specifically excluded or deferred. The second type of income is recognized income. This is the part of realized income that's actually reported on the tax return. Again, taxpayers should assume all realized income is recognized income. That is, it should show up on the tax return unless there's a law that says the taxpayer doesn't have to. However, realized income could be different from recognized income for a couple of reasons. First, the realized income may be excluded entirely from the tax return. Going back to my earlier example about selling my home, there is in fact a provision in the tax code, section 121 that allows me to exclude a large portion of the gains from the sale of my primary residence if certain rules apply. Therefore, the $50,000 realized gain I earned on the sale of my home will not be recognized. So that $50,000 will not be reported on my tax return due to section 121. That income will be tax-free. A second reason there may be a difference between realized income and recognized income, is because the income is deferred from tax. That is maybe I realize income this year, but I don't actually have to report it on my tax return until sometime in the future. An example here is what's known as an installment sale. Here the tax law force me some opportunity to spread the recognition of my gains across several years into the future. Here's a partial list of some other items that are included in gross income. That's a taxpayer will recognize and report on the tax return. We'll talk about some of these during the course. For example, alimony, the income element of annuities, bonuses, business income, commissions, debt forgiveness, dividends, and in fact, we have embezzled funds. Again, although an activity could be illegal, it's still income from whatever source derived and therefore must be included on the tax return in calculating the tax base. Other incredible income items are income from hobbies, interest that I earned from a bank or from most bonds, pensions, punitive damages, rents, rewards, salaries, tips, and even a treasure I find. For example, if I find $20 lying in the street and I pick it up and keep it, technically it's gross income and must be reported on my personal income tax return. Here's a partial list of exclusions or income that taxpayers do not have to include on their tax returns. They may be realized income, but it's not recognized income. We'll talk about some of these as well during the course. Examples include accident insurance proceeds, the cost portion of annuities, gifts and inheritances that I've received, child support payments received, any damage awards received for physical injuries, interest from municipal bonds, life insurance proceeds received when somebody dies, meals and lodging if some conditions hold, scholarships, some or all Social Security benefits received, and workers compensation benefits. Again, we'll dig deeper into many of these gross income items and exclusions as the course progresses.
