Calculating Federal Tax Liability
Learn how a taxpayer's federal tax liability is determined using gross income, adjusted gross income, exclusions, deductions, allowances, credits, and marginal tax rates.
In this lesson, we'll survey the basic process to calculate federal income-tax liability for an individual who lacks capital gains and isn't subject to the alternative minimum tax. Along the way, we'll introduce ourselves to some key concepts we'll be revisiting throughout this course.
The first step is determining the taxpayer's gross income, because only gross income is potentially subject to federal income taxation. See 26 U.S.C. § 63(a). The Internal Revenue Code, or IRC, somewhat circularly defines gross income as, quote, "all income from whatever source derived," unquote. Id. at § 61(a). The IRC lists examples of gross income, including compensation for services, business income, rents, interest, and so on. Id.
However, Congress has chosen not to tax gain from particular sources, although the gain would otherwise constitute gross income. These untaxed gains are called exclusions, as the statute excludes them from gross income. See Comm'r of Internal Revenue v. Jacobson, 336 U.S. 28 (1949). An example is the exclusion for gifts and bequests. See 26 U.S.C. § 102.
Once a taxpayer's gross income is calculated, the next step is to compute the taxpayer's adjusted gross income. See id. at § 63. This calculation is done by subtracting, from gross income, the value of the specific deductions listed in IRC Section Sixty-Two (a), also called above-the-line deductions. These include deductions for items such as student-loan interest, many business expenses, and losses on the sale or exchange of property. See id. at §§ 62(a), 63(a).
Once adjusted gross income is determined, the next step depends on whether the taxpayer elects to take the standard deduction or to itemize deductions. If the taxpayer elects the standard deduction, then she'll simply subtract a fixed amount from adjusted gross income. This amount consists of the basic standard deduction plus, if appropriate, an additional fixed deduction for elderly or blind taxpayers. The amount of the basic standard deduction varies, depending on the taxpayer's filing status. See id. at § 63.
If the taxpayer itemizes, then she can't take the standard deduction. Instead, she must subtract, from adjusted gross income, the value of all itemized deductions, also termed below-the-line deductions. Itemized deductions include most allowable deductions under the IRC, excluding above-the-line deductions, the deduction for qualified business income, and any personal exemptions. Id.
Once either the standard deduction or total itemized deductions are subtracted from adjusted gross income, the next step is to apply the deduction for qualified business income, if appropriate. Id. at § 199A. If the taxpayer itemizes, this deduction is treated like just another itemized deduction and subtracted from adjusted gross income. See id. at § 63(a). If the taxpayer takes the standard deduction, then the qualified-business-income deduction is taken in addition to the standard deduction and, again, subtracted from the total. Id. at § 63(b)(3). Thus, taxpayers benefit from the qualified-business-income deduction whether they itemize or take the standard deduction.
The qualified-business-income deduction applies only to taxpayers who earn income as sole proprietors or as co-owners of business entities that aren't taxed separately from their owners. Also, the deduction will apply only to taxable years twenty eighteen through twenty twenty-five, unless Congress extends it. See id. at § 199A; Jerald David August, Proposed Regulations under Section 199A: Qualifying for the 20% Business Deduction, 45 WGL-CTAX 14 (Nov./Dec. 2018).
Now is a good time to talk about personal exemptions. Historically, similar to the qualified-business-income deduction, personal exemptions represented fixed amounts that most taxpayers could subtract from adjusted gross income, in addition to the standard deduction or any itemized deductions. Generally, taxpayers received personal exemptions for themselves and, if appropriate, for their spouses and dependents. See 26 U.S.C. §§ 63(a)-(b), 151.
We're speaking of personal exemptions in the past tense because Congress has set the personal exemptions for most taxpayers to zero, for taxable years twenty eighteen through twenty twenty-five. See id. at § 151(d)(5). Congress also greatly enlarged the basic standard deductions for those years. Id. at § 63(c)(7). We mention personal exemptions here because they'll return in twenty twenty-six, if Congress doesn't act. Also, if you encounter tax returns for taxable years twenty seventeen or earlier, you'll need to take personal exemptions into account.
Once either the standard deduction or the itemized deductions have been subtracted from adjusted gross income, and any qualified-business-income deductions or personal exemptions have been accounted for, the resulting amount is the taxpayer's taxable income. Id. at § 63(a)-(b).
The next step to calculate tax liability, then, is to multiply taxable income by the applicable tax rates. And we say tax rates, plural, because discrete portions, or brackets, of the taxpayer's income may be subject to different tax rates, due to our progressive system of marginal income taxation. See id. at § 1.
The idea behind any progressive tax system is that taxpayers with higher incomes should bear more of the overall tax burden. See Vada Waters Lindsey, The Widening Gap Under the Internal Revenue Code: The Need for Renewed Progressivity, 5 Fla. Tax Rev. 1 (2001); Yoseph Edry, Constitutional Review and Tax Law: An Analytical Framework, 56 Am. U. L. Rev. 1187 (2007). In the United States, progressivity is achieved by dividing taxable income into brackets and subjecting higher brackets to higher tax rates. To illustrate, we'll use the basic tax tables that took effect on December 22nd, 2017, for single taxpayers, disregarding inflation adjustments. You'll see that information on your screen. If you can, please pause the video and take a moment to review it.
Once taxable income has been multiplied by the appropriate tax rates, the resulting amount is the taxpayer's tentative tax liability. We say tentative because there's another step to arrive at the taxpayer's final tax liability. That's to subtract, from tentative tax liability, the dollar value of any tax credits.
Don't confuse deductions with credits. A deduction reduces taxable income. A tax credit represents a dollar-for-dollar reduction in tax liability. See Internal Revenue Service, Credits and Deductions for Individuals, https://www.irs.gov/credits-deductions-for-individuals. A common credit is the earned-income tax credit, a special entitlement for low-income taxpayers. See 26 U.S.C. § 32.
If the difference between tentative tax liability and tax credits is positive, then that is the final tax liability. If the difference is zero, the taxpayer owes nothing. If the difference is negative, then the distinction between refundable and nonrefundable credits comes into play. If a credit is refundable, then any resulting negative balance will be treated like a tax overpayment, producing a tax refund. If a credit is nonrefundable, then the most it can do is to reduce tax liability to zero. Nonrefundable credits can't be treated as overpayments that produce refunds. See id. at § 6401(b)(1); Tax Policy Center, Briefing Book, https://www.taxpolicycenter.org/briefing-book/what-difference-between-refundable-and-nonrefundable-c....
Finally, the taxpayer must, of course, receive credit for any tax withholdings or estimated-tax payments for the taxable year. See 26 U.S.C. §§ 31(a), 6315.