Income Tax 2021 2022 Income Tax formula, get ready to get refunds to the max diving into income tax 2021 2022, we’re going to start looking at the tax formula. In one note, if you have access to one note, you could follow along. If not, that’s okay too. Later on, we’re going to be looking at the formula with the use of Excel.
Typically, in practice, I’ll use something like this so that I can double check what has been input into the system into the tax software with an outside possibly more transparent worksheet in Excel.
So we’ll take a look at that in future presentations, you also might want to have a form 1040, which you could find on the IRS website, irs dot Govt.
So you can compare the formula to the 1040. Here’s our 1040 in our tax software with our mock client that being Adam Smith, living in Beverly Hills, 90210. And you can kind of compare the information down below.
And you can see you have basically an extended format of the tax formula tax software, we’re also often have a tax summary kind of page, which will give you the information in more of a formula basis as well. We’ll take a look at that more in a future presentation.
So let’s go back on over to one note, note. And the first thing you want to think about is and understand is the income tax is a tax on income. That means the first part of the tax formula is going to be some kind of income statement,
a standard income statement you would think of as income minus expenses. That would mean that any natural deduction that you would expect would be deductible would be something that you had to use or expend in order to generate income.
So a natural kind of way that you would think about an income tax is that you would say I’ve got my income that’s going to be on the top line item. And then what kind of deductions would naturally be appropriate for an income tax.
Normally, you would think of the type of deductions that you needed to expand in order to generate revenue would be the type of expenses that would be natural to an income tax, so that the income tax has not been given on the gross income, the top line would actually on the net income, the income that you had, after having to expend the expenses in order to generate income.
Obviously, the tax codes gonna deviate from that a lot, because the tax code is not just there for revenue generation, it’s also basically used to influence us in some ways.
So when you start to think about the things that are deductible, you’re going to start to say, hey, wait a sec, that’s not like something that is used in order to generate income, it’s got some other purpose, aim or goal, which is the reason the legislation has been put into place, which makes the income statement in the income tax a little confusing, not a standard kind of income statement.
But that’s the first starting point you want to think about, we’re doing an income tax, we’re going to get taxed on basically the bottom line of the taxable income statement, that will start off with income, which we can think about as gross income. Now we’re going to dive into more detail of each of these line items in the formula.
When we look at the top line, which we would typically think of as gross income in an income statement, that’s even going to be a bit more confusing, because it’s going to include things which we could think of as gross and income like w two wages. But it will also include things that are from our sole proprietorship that could be reported like on a schedule C, and the schedule C will have an income statement for the business,
which we would imagine more of a common income statement with the gross income minus all the deductions, which in that case, are expenses that are used, in order to generate the revenue, the net income is going to pull into the first page of the 1040, and B in this first income line item.
So this formula, again, is is a simplified formula that we can kind of hold in our mind, we’re gonna have to expand on it, to think about what kinds of things are going to fit into these particular line items, and how much detail we got to think about in order to think about different changes that are going to happen such as,
What if someone has a Schedule C business, and so on, and so forth, and deductions and income related to it. So then we’re going to have the deduction or subtraction of and you can think about these as deductions,
there’s typically two, you want to think in your mind, two major categories of deductions for the individual income tax return, we are in essence, murine here, the form 1040, we have what we could call, there’s sometimes called above the line deductions.
And sometimes they’re gonna they could be called a schedule one deduction now because there’s been changes in there on a different schedule at this point in time.
And they could be called adjustments to income. So these are kind of the above the line or adjustments to income as opposed to the standard deduction or the itemized deductions, that’s going to give you the adjusted gross income, the AGI.
Now, this above the line deductions, there’s not as many of them so we’ll be we’ll be able to kind of we’ll go through those will expand on what those deductions are. But those if you can get those deductions, those have a benefit.
Over the itemized deductions, which are possibly the more common deductions that used to usually come to mind when we’re thinking about deductions.
Because these adjustments to income or above the line deductions or schedule one deductions are not subject to the same kind of either or requirement that we will see in the itemized deductions. In other words, I don’t have to clear some kind of hurdle, like a standard deduction in order to take them or in other words,
I can take the standard deduction and still be able to take the adjustments to income in general, they’re not linked to whether or not I take a standard deduction, or whether I am itemizing.
This subtotal is just going to be a subtotal on the way down to the bottom of the income statement similar to like a multiple step income statement to get down to a nor in a normal income statement terms and down to net income, in this case, to taxable income.
But this number is going to be really important, the adjusted gross income or AGI, the reason that’s really important is because a lot of times when you’re thinking about credits, or when you’re thinking about deductions, they have a phase out characteristic. In other words, the tax code is often going to say,
if your income goes above a certain level, we’re going to start to phase out the benefits that you get from certain deductions and credits. And they’re typically not going to be basing it on the top line, the income, they’re at least going to start out basing it on the AGI.
So when we say there’s an income limitation, usually more technically, it would be an adjusted gross income based limitation, not on the top line, they could be pretty closely related, depending on how many adjustments to income there might have.
So it’s a good key number to keep in mind. And then we’re going to be subtracting either the standard deduction and the itemized or the itemized deduction. Here’s where the confusion mostly comes in with people,
because the standard deduction is a deduction that will be will be standardized. And it’ll be based on in essence, your filing status and a couple other conditions that we’ll talk about later. So we’ll get into the dollar amounts of a standard deduction.
But the general idea is, you’re going to have one standard deduction, or one set of standard deductions based on your conditions. And, and that’ll be it. Or if you have itemized deductions that are over a certain amount, you can take the itemized deductions.
So the itemized deductions include those types of deductions that often come to mind. When we think about deductions, like the charitable deduction, there’s there’s an above the line component, so so it gets a little bit more tricky. But you know, most of the time that most of the charitable deductions are on the itemized deductions.
When you think about deductions related to interest, and taxes or mortgage taxes, I’m sorry, mortgage interest and property taxes, for example, those are going to be the itemized deductions.
And so when you’re thinking about, you know, what’s going to be the impact on your taxes, you’ve got to think about the interplay between these two items. Now, note, there’s often an argument within the tax law saying,
I mean, should we simplify the tax code by lessening the amount of deductions possibly giving a greater standard deduction, versus having the itemized deduction. So when they try to simplify the law, they’re often saying,
Okay, what we’re going to do is try to increase the standard deduction, so that everybody just has a standard deduction. And we’re not going to get into all this itemized deduction business, you’ll note that the itemized deductions includes a lot of items, that, once again,
they’re not those kinds of things that you would think would be natural to an income tax, because you would think the things that would be deductible would be those expenses that you need to expend in order to generate revenue.
And oftentimes, when we look at the deductions that here, such as a personal residence, you know, mortgage interest deduction, and the property taxes and whatnot, those are on personal things.
So you would think there’s some other driving factor or incentive as to why they became deductible, other than what would be natural to an income tax. So oftentimes, you’ll hear arguments on the income tax code saying, well,
we should simplify the tax code, versus we should increase the itemized deductions, having them give them more influence, so that we can do things with the tax code and influence people’s behavior through the tax code.
Those are often going to be you know, two angles that people think about with tax policy, do we want to use the tax code to influence people? Well, that’s usually going to mean that it’s going to be a more complex tax code.
And that would mean people would probably be favoring more power to the itemized deductions so that they can use those to, you know, drive people to do this, that the other thing based on tax influences.
If you’re trying to simplify the tax code, then you’re probably saying, well, now I want to lessen the role of the itemized deductions, and just have a standard deduction.
Also, the itemized deductions probably, of course, favor more well off individuals, because you’re more likely to be itemizing. If if you’re more well off, generally, you’re going to have more deductions that are going to be over the standard.
So the general rule then would be, you’re going to take the standard deduction, if it’s greater than the itemized deduction,
you would only be taking the itemized deductions if they were greater than the standard deduction because you want the maximum benefit for taxes, benefit for taxes means that the expenses, which are in essence, the deductions are good, everything’s flipped on its head for taxes.
So and that’s a key component. Remember, when you’re on the, when you’re on your business side of things, if you are trying to get a loan, for example, for your business or something like that, you’re going to the bank, you’re trying to look good, you’re in your best suit.
Right, you’ve got your income statement, you’re trying to say, this is how much I’m making. And you’re trying to say, I make enough money to pay back the loan, give me a loan, please.
When you’re talking about taxes, everything is flipped on its head, you’re trying to look bad. You can imagine visiting the tax person with holes in your genes and so forth, you’re not actually going to do that.
But that would be more. Right? I don’t have any money, right? The expenses are good. The income, the income is bad for taxes, because it’s an income tax.
So that means what we want to do is take the biggest amount of deductions we can, which would basically be kind of like expenses, if you’re thinking about a normal type of income statement. So we would only take the itemized deductions if they’re greater than the standard deduction.
That means that when you’re thinking about itemized deductions, you got to think about is it worthwhile for me to collect a bunch of the itemized deductions, things like medical expenses, and so forth, can get quite tedious to to be collecting the data on if I don’t, if I’m not going to be able to get a benefit from them.
So we’ll break down some of those itemized expenses, when we get into that section of the course, then the next line is going to be the taxable income.
So you kind of think about this as the bottom line of the income statement portion of the tax formula, we’re not done yet, because we have to calculate the taxes. And then we also have the more the complexities of the credits,
which are different than the deductions. And then we also have the fact that we already made payments on it. So we’re really only halfway to the end of the actual calculation here.
But this is this is the part that you kind of are verifying, oftentimes, when you’re filling out the 1040, to see what your taxable income will be, this would be kind of equivalent to the net income. If you thought about just the normal income statement, basically, income, gross income minus expenses, we’ve got the the income up top minus the adjustments to income,
which are kind of like above the line deductions to get to that AGI, then you take either the standard deduction, which would typically be easier and normally applies to most, you know, taxpayers unless your income is over a certain threshold.
Also remember that, you might say, Well, what’s going to be the factor that basically triggers people to itemize, it’s usually something like a home when they purchase a home,
that’s one of the biggest deductions because you’re going to be financing a lot of it. And oftentimes, the mortgage interest is going to be deductible, as well as the property taxes. And that’s huge deduction that pushes a lot of people over to itemizing.
But be careful when you’re purchasing a home, that if someone’s if they’re arguing that you should purchase the home, just to get the deductions of the mortgage interest, you got to be careful on that. Because the benefit that you’re getting, is it really the full deduction of the itemized deduction, because you would have got the standard deduction.
Anyways, the real benefits you’re getting is the difference between how much standard deduction you would have gotten and how much more benefit you got on the itemized deduction.
So once again, for a lot of people, it might not be as big a difference as you would think, for more wealthy people that might have two houses or something like that, and have, you know, a lot of you know, larger house and therefore larger financing, then it’s more likely, again, to be a bigger significant thing to be to be itemizing, and so on.
So in any case, that’s going to be the taxable income, so then, we’re going to apply the tax rates, you can think about it or in essence, the tax table, this is where we’re going to actually apply that calculation of the tax.
This is something that we as tax preparers aren’t usually doing by hand, we looked about, we looked at this in the past, because we would have to apply the progressive tax system,
meaning the different rate tables, and so on, which and if you were to do this with the tables with the actual tables in the instructions for the 1040, you would look up the tables, that’s how the software will typically calculate it.
And so So again, we really rely on the software for this. So in other words, normally, we can double check this number up top, possibly with an Excel worksheet, as we will do,
we’ll double check these numbers, then we’ll rely oftentimes on the tax software to do the actual calculation because it’s a progressive tax, it’s complicated to figure out that rate, because you got to look it up in a table number one and number two,
it’s not just a table because you might have more detail than that you might have to break out the capital gains rates which could be different as well as the the dividends rates could be different. So once you once you’ve got the tax rate that’ll give you the the tax before credits and other taxes.
So you would think this would be the bottom line of what you owe. But no, you also have to The credits that are going to they’re going to take place. They’re confusing component about the credits, as they kind of combine the credits,
together with the payments in the tax formula, because the credits are equivalent in value to basically something that you paid in to the system.
So you got to be careful when you’re thinking about a deduction versus a credit when you’re thinking about a deduction. If you’re talking about $1 of a deduction, or $1 of credits, the credit will be worth more than the deduction. So in other words, if you had a deduction, you got to think, do I even get the deduction?
Because if it’s an itemized deduction, it’s not going to help me if I’m standardizing so first of all, if am I going to get the deduction, if it’s going to give you a benefit on the deduction side of things, say it’s say it’s an adjustment from adjustment, it’s an adjusted gross income deduction or an adjustment to income deduction,
then you’re only going to get a benefit based on basically the rate that is going to be applied to that dollar of the deduction. So you’re only going to get a portion of the benefit of that deduction. Whereas if it’s a credit, you’re going to get that full dollar worth of a credit.
So $1, for dollar duction deduction versus a credit with a credit is going to be worth more than the deduction, that’s going to be the general rule that that you want to keep in in mind. So then we’re going to subtract or add the tax credit and other taxes.
So the credits are going to be things once we’re down here, we’re now looking at the tax, this is basically what our liability would be if we had not already paid into the system, which we have.
Because the IRS wants to get paid as we go for most people, they get paid by your employer or taking money out of your W two and paying it to the IRS on your behalf.
But then we also have the credits, that are going to subtract, we’re going to reduce the liability, what your liability would be for the taxes minus the credit. So that’s good, because that would make your liability go down.
But we could also have other taxes that could be involved down here that we’re going to apply that are not the income tax is one of the biggest examples often being self employment tax. So for example, if you work in you have a schedule C business, then you have to you if you’re if you’re a W two employee,
you have to pay Social Security and Medicare and the income tax through payroll taxes. If you’re a sole proprietorship, then you’re not paying the payroll taxes for your income that you’re earning. The IRS wants that money.
So they’re gonna include it in self employment tax is one of the big taxes for many people, that people often hit people unaware of, of how that’s going to happen, because they’re so used to being an employee, when they move to self employed,
they’re calculating just on the federal income tax and forgetting about the Social Security and Medicare, which in essence of the payroll taxes that are now being applied to them as a sole proprietorship in the form of self employment taxes.
So those are going to be added that could be added down here, depending on the type of business, if you’re a W two employee, then you’ve already paid those taxes because the employer Earth took them out of your wages, because they were forced to by the government.
And so they took them out, you’re paid them already, typically. So that’s going to give us then the what we’ll call the total tax here. So we had the tax before. We had the tax before credits and other taxes. And then we applied out the credits and the other taxes.
So now we’re saved the total tax, which would be your liability if you had not already paid in to the system, but you’re half paid into the system. Because you because that’s what the government wants, right? They want you to be paying into the system as the year goes.
So for talking about tax year 2021, the government wants to be paid in 2021, even though you don’t file the tax return until April 15 of 2022. Or somewhere there abouts, possibly April 18, of 2022.
So they want the money during the timeframe. Now, if the way the tax system was kind of designed, it would work something like this in a perfect world, what would happen is that you earn revenue, and you pay the government vendor share of the revenue as you earn it throughout 2021.
When you file the tax return by April 18, or 15th, or whatever of the next year 2022. It should just be an information return. In a perfect world. In other words, you would have the total tax liability that you recalculated,
and then you would tell the government and I already paid it throughout the year possibly through withholdings for my w two wages, and therefore you would have no refund and no tax do. That’s how it’s kind of designed to do.
However, that’s impossible to do due to the complexity of the tax code. In other words, it’s impossible for us to pay the exact amount of tax that we owe, because we have a progressive tax system with multiple tiers because we have you know, multiple people that could be combined on one return because we got credit that are going to distort the whole thing as well.
So it’s way too complicated for us to ever get the exact tax calculated. So that means that what we try to do a shoot for the refund, that’s why you have a refund.
And you can see this in the payroll taxes, if you’ve ever dealt with payroll taxes, it uses more of a flat tax, and you file the 940 ones quarterly. And normally, if you do things properly, because it’s a more simple tax, it’s it’s using the same system on a quarterly basis. But when you actually file the tax return, you’re not paying any more tax at that point in time.
You’re just saying, hey, look, this is how much tax I owe, based on the calculation, I already paid you it. When I process the payroll, there’s no tax, there’s no there’s no refund at that point in time. That’s kind of how the, the the income tax was designed to be. But it’s way too complex to do that.
Because we don’t have a flat tax. And because the income is confusing, because the deductions are, you know, get out of control. And the credits are a mess, and so on. So what we do then is we try to say I’m going to shoot to overpay the taxes.
So when you look at your tables for the W two withholding tables and so on, they’re designed to overshoot the taxes if so if you calculate it properly, based on you know, the directions for the for the filling out your W four, in order for the withholdings to be taken out of your W two,
they’re designed to overshoot, so that you pay too much, and that and that’s what you’re getting in terms of the refund in normal cases. So now you got the tax payments, which hopefully you paid a little too much, in that case to get a refund.
Why did they try to overshoot it instead of undershoot it? Is it so that you can get a nice surprise of a refund? It’s not that’s you know, that might be part of it from from it.
But really what you’re trying to do on your side of things, is you’re trying to avoid paying penalties and interest. This, you know, how does the IRS kind of enforce this whole system, they have a stick, they got the stick that they hit people with it’s called penalties and interest.
So if you underpaid the tax, they’re going to hit you with the stick of penalties and interest we’re trying to we don’t want to I don’t like getting hit with the stick.
So what you’re trying to do is overpay a little bit so that you can avoid the penalties and interest because you can’t exactly hit exactly what the what the amount of tax you’re going to owe is. So that means that that you’ve got the tax payments down here.
And then the refundable credits, we’ll talk more about refundable credits, they’d become more and more significant. Those are things like the Child Tax Credit, which has an advanced portion to it now.
And you’ve got the earned income credit, which are the two big refundable credits, and possibly the recovery rebate credit tied to the to the economic stimulus payments.
So those those are also going to be down here. refundable means that we could go below the the tax and we could not only not owe any tax, and not just get a refund back because we overpaid the tax but actually get money.
So in that case, if you were using the refundable portion of a refundable credits, you would be getting getting money, you know, it’s not like you would be paying tax in that case, you would be receiving money through the tax code while filing your tax return.
And it wouldn’t really be a refund in that case, even though it’s still kind of clinical to refund, it would be, you know, a benefit kind of program. So those, that’s why they’re down here in the refundable credits section. So we’ll talk more about those later.
And then finally, we get to the tax refund or the tax due at the bottom line. So this is basically mirroring the the the actual 1040 every line item on here, we can then supplement with another schedule that might help us to give us more details. So for example, the income line item might be supplemented with a Schedule C,
a Schedule E that helps break down more of that information. The adjustments might be on a schedule one to tell us what actual those adjustments are.
The itemized deductions is going to be on a schedule A that breaks down the actual itemized deductions. So you can think about it. If you were thinking about an Excel worksheet format, you’d say okay, this is the first sheet, which is the summary sheet summary formula.
And then I’m going to break down each of these line items with a separate sheet that feeds into that first line item. When you’re envisioning it in your mind, then if someone asks you a question, and you’re saying,
Okay, you got a Schedule C thing that’s going to ultimately feed into the first line item of the income statement, it will have an ultimate impact on taxable income of this and so on.
That’s how you kind of want to visualize it, oh, you have something that’s an adjustment to income that which would fall in here, which you would have a deduction to the adjusted gross income,
which could have an impact on your face outs and so on for other credits and whatnot. Oh, you have something that’s an itemized deduction. That would be kind of here that would be going on your schedule A would flow into this portion on the first page of your formula.
That’s how you want to start to visualize in your mind what’s going to happen. And then and then you want to solidify that by doing practice, practice. With the use of say Excel worksheets and of course with the use of software