10. Effective Tax Planning. Explain the key elements of effective tax planning. What are
some of the most poplar tax management strategies?
The income tax is computed as taxable income times tax rate. So, to reduce the income tax, you
may reduce taxable income or reduce the tax rate. Taxable income may be reduced that shifting
11. Effective Tax Planning. Denise Hughes reports the following data from her 2018 tax
return. Analyze the data and suggest tax planning ideas that she should consider.
Salary $150,000
Interest Income 30,000
Qualified dividends 1,000
Adjusted Gross Income $181,000
Note: The interest income is from a bank savings account earning 1%. The dividends are
from a stock paying 3 percent dividends.
“Test Yourself” Questions are taken from previous editions of the text. You may
used them as quiz questions or as additional homework.
3-1 What is a progressive tax structure and the economic rationale for it?
3-2 Briefly define the five filing categories available to taxpayers. When might married
taxpayers choose to file separately?
The five filing statuses are:
3-3 Distinguish between gross earnings and take-home pay. What does the employer do with
the difference?
3-4 What two factors determine the amount of federal withholding.
3-5 Define and differentiate between gross income and AGI. Name several types of tax-
exempt income. What is passive income?
3-6 What is a capital gain, and how is it treated for tax purposes?
3-7 If you itemize your deductions, you may include certain expenses as part of your
itemized deductions. Discuss five types of itemized deductions and the general rules that
apply to them.
Medical expenses—deductible if they exceed 10% of adjusted gross income
State and local taxes—Only income taxes and property taxes where the property tax is based
3-8 NO Personal Exemptions from 2018-2025 Dan Caldwell was married on January 15,
2018. His wife, Catherine, is a full-time student at the university and earns $625 a month
working in the library. How many personal exemptions will Dan and Catherine be able to
claim on their joint return? Would it make any difference if Catherine’s parents paid for
more than 50 percent of her support? Explain.
3-9 Define and differentiate between the average tax rate and the marginal tax rate.
How does a tax credit differ from an itemized deduction?
3-10 Explain how the following are used in filing a tax return: (a) Form 1040, (b) various
schedules that accompany Form 1040, and (c) tax rate schedules.
a. Form 1040 is the main form used in filing federal income taxes. All individuals filing
may use Form 1040 accompanied by appropriate schedules as needed to file their tax
3-11 Define estimated taxes and explain under what conditions such tax payments are
required.
3-12 What is the purpose of a tax audit? Describe some things you can do to be prepared if
your return is audited.
3-13 What types of assistance and tax preparation services does the IRS provide?
3-14 What are the advantages of using tax preparation software?
3-15 Differentiate between tax evasion and tax avoidance.
3-16 Explain each of the following strategies for reducing current taxes: (a) maximizing
deductions, (b) income shifting, (c) tax-free income, and (d) tax-deferred income.
3.1 The Andersons Tackle Their Tax Return
Noah and Olivia Anderson are a married couple in their early 20s living in Dallas. Noah
Anderson earned $73,000 in 2018 from his job as a sales assistant. During the year, his
employer withheld $4,975 for income tax purposes. In addition, the Andersons received
interest of $350 on a joint savings account, $750 interest on tax-exempt municipal bonds,
and dividends of $400 on common stocks. At the end of 2018, the Andersons sold two
stocks, A and B. Stock A was sold for $700 and had been purchased four months earlier for
$800. Stock B was sold for $1,500 and had been purchased three years earlier for $1,100.
Their only child, Logan, age 2, received (as his sole source of income) dividends of $200
from Hershey stock. Although Noah is covered by his company’s pension plan, he plans to
contribute $5,000 to a traditional deductible IRA for 2018. Here are the amounts of money
paid out during the year by the Andersons:
Medical and dental expenses (unreimbursed) $ 200
State and local property taxes 831
Interest paid on home mortgage 4,148
Charitable contributions 1,360
Total $6,539
In addition, Noah incurred some unreimbursed travel costs for an out-of-town business
trip:
Airline ticket $250
Taxis 20
Lodging 60
Meals (as adjusted to 50 percent of cost) 36
Total $366
Critical Thinking Questions
1. Using the Andersons’ information, determine the total amount of their itemized
deductions. Assume that they’ll use the filing status of married filing jointly, the standard
deduction for that status is $24,000. Should they itemize or take the standard deduction?
Medical and dental expenses (unreimbursed)
$200 less 10% of AGI, thus 0 deductible
State and local property taxes
831
Interest paid on home mortgage
4,148
Charitable contributions
1,360
Employee business expense
Travel costs 366 less 2% of AGI, thus 0
deductible In 2018-2015, no deduction for
miscellaneous deductions subject to thee 2%
reduction
Total Itemized Deductions
$6,339 – Standard is higher
Prepare a joint tax return for Noah and Olivia Anderson for the year ended December 31,
2018, that gives them the smallest tax liability. Use the appropriate tax rate schedule
provided in Exhibit 3.3 to calculate their taxes owed.
Taxable Income 47,250
Less income subject to the capital gains tax:
2. How much have you saved the Andersons through your treatment of their deductions?
3. Discuss whether the Andersons need to file a tax return for their son.
4. Suggest some tax strategies that the Andersons might use to reduce their tax liability for
next year.
3.2 Cheryl Stern: Waitress or Tax Expert?
Cheryl Stern, who is single, goes to graduate school part-time and works as a waitress at
the Sunset Grill in Seattle. During the past year (2018), her gross income was $18,700 in
wages and tips. She has decided to prepare her own tax return because she cannot afford
the services of a tax expert. After preparing her return, she comes to you for advice. Here’s
a summary of the figures that she has prepared thus far:
Gross income:
Wages $10,500
Tips 8,200
Adjusted gross income (AGI) $18,700
Less: Itemized deductions −2,300
$16,400
Less: Standard deduction −6,200
Taxable income $10,200
Cheryl believes that if an individual’s income falls below $20,350, the federal government
considers him or her “poor” and allows both itemized deductions and a standard
deduction.
Critical Thinking Questions
1. Calculate Cheryl Stern’s taxable income, being sure to consider her exemption. Assume
that the standard deduction for a single taxpayer is $12,000.
2. Discuss Cheryl’s errors in interpreting the tax laws, and explain the difference between
itemized deductions and the standard deduction.
3. Cheryl has been dating John Brooks for nearly four years, and they are seriously
thinking about getting married. John has income and itemized deductions that are identical
to Cheryl’s. How much tax would they pay as a married couple (using the filing status of
married filing jointly and a standard deduction of $24,000) versus the total amount the two
would pay as single persons (each using the filing status of single)? Strictly from a tax
perspective, does it make any difference whether Cheryl and John stay single or get
married? Explain.
Terms Found in the Chapter
adjusted gross
income (AGI)
The amount of income remaining after subtracting all allowable
adjustments to income from gross income.
adjustments to
(gross) income
Allowable deductions from gross income, including certain
employee, personal retirement, insurance, and support expenses.
amended return
A tax return filed to adjust for information received after the
filing date of the taxpayer’s original return or to correct errors.
average tax rate
The rate at which each dollar of taxable income is taxed on
average; calculated by dividing the tax liability by taxable
income.
estimated taxes
Tax payments required on income not subject to withholding
that are paid in four installments.
exemptions
Deductions from AGI based on the number of persons supported
by the taxpayer’s income.
Federal Insurance
Contributions Act
(FICA), or Social
Security tax
The law establishing the combined Old-Age, Survivor’s,
Disability, and Hospital Insurance tax levied on both employer
and employee.
federal withholding
taxes
Taxes—based on the level of earnings and the number of
withholding allowances claimed—that an employer deducts
from the employee’s gross earnings each pay period.
gross income
The total of all of a taxpayer’s income (before any adjustments,
deductions, or exemptions) subject to federal taxes; it includes
active, portfolio, and passive income.
income shifting
A technique used to reduce taxes in which a taxpayer shifts a
portion of income to relatives in lower tax brackets.
income taxes
A type of tax levied on taxable income by the federal
government and by many state and local governments.
itemized deductions
Personal expenditures that can be deducted from AGI when
determining taxable income
marginal tax rate
The tax rate that you pay on the next dollar of taxable income.
progressive tax
structure
A tax structure in which the larger the amount of taxable
income, the higher the rate at which it is taxed.
standard deduction
A blanket deduction that depends on the taxpayer’s filing status,
age, and vision and can be taken by a taxpayer whose total
itemized deductions are too small.
tax audit
An examination by the IRS to validate the accuracy of a given
tax return.
tax avoidance
The act of reducing taxes in ways that are legal and compatible
with the intent of Congress.
tax credits
Deductions from a taxpayer’s tax liability that directly reduce his
or her taxes due rather than taxable income.
tax deferred
Income that is not subject to taxes immediately but that will be
subject to taxes later.
tax evasion
The illegal act of failing to report income or deductions
accurately and, in extreme cases, failing to pay taxes altogether.
taxable income
The amount of income subject to taxes; it is calculated by
subtracting adjustments, the larger of itemized or standard
deductions, and exemptions from gross income.
taxes
The dues paid for membership in our society; the cost of living
in this country.
Chapter Outline
Learning Goals
I. Understanding Federal Income Tax Principles
A. The Economics of Income Taxes
B. Your Filing Status
C. Your Take-Home Pay
II. It’s Taxable Income That Matters
A. Gross Income
1. Three Kinds of Income
2. Capital Gains
a. Selling Your Home: A Special Case
B. Adjustments to (Gross) Income
C. Deductions: Standard or Itemized?
1. Standard Deduction
2. Itemized Deductions
3. Choosing the Better Option
D. Exemptions
III. Calculating and Filing Your Taxes
A. Tax Rates
B. Tax Credits
C. Tax Forms and Schedules
D. The 2018 Tax Return of David and Violet Duncan
1. Finding the Duncan’s 2018 Tax Liability: Form 1040
a. Gross Income
b. Adjustments to Gross Income
c. Adjusted Gross Income (AGI)
d. Qualified Business Income Deduction
e. Itemized Deductions or Standard Deduction?
f. The Duncan’s Taxable Income and Tax Liability
g. Do They Get a Tax Refund?
E. Issues for High Income Taxpayers
IV. Other Filing Considerations
A. Estimates, Extensions, and Amendments
B. Audited Returns
C. Tax Preparation Services: Getting Help on Your Returns
1. Help from the IRS
2. Private Tax Preparers
D. Computer-Based Tax Returns
V. Effective Tax Planning
A. Fundamental Objectives of Tax Planning
C. The Tax Return and the Financial Planning Process