 Income tax 2023 2024 income tax formula get ready and some coffee so we can stave off the government attack with income tax preparation 2023 2024 first a word from our sponsor yeah actually we're sponsoring ourselves on this one because apparently the merchandisers they don't want to be seen with us but but that's okay whatever because our merchandise is is better than their stupid stuff anyways like our trust me I'm an accountant product line yeah it's paramount that you let people know that you're an accountant because apparently we're among the only ones equipped with the number crunching skills to answer society's current deep complex and nuanced questions if you would like a commercial-free experience consider subscribing to our website at accounting instruction comm or accounting instruction dot think of it comm in prior presentations we took a look at the different approaches the different tools that we will use to understand income tax preparation income tax laws those including the formula method a formula being something that we can typically visualize more easily it being more distilled than say the tax forms and is great for understanding conceptually then we have the actual tax forms noting that the formula is within the tax forms in other words when we calculate the tax forms there will be a formula to it but it's more of an expanded type of formula that's not really distilled down to its essence and then we have the software the software of course having the forms within it and the forms having the formulas within the forms but the software adds another layer for us to understand with that allowing us quick data input into the software and looking at the result in the format of the tax forms and then trying to distill the tax forms down to its essence which in essence would be the simplest type of formula at this time we want to focus in on the formula so we're going to basically go through line item by line item of the formula as we do so you can kind of imagine that each of these line items are going to have more things that could be included within them in other words whatever you have a tax question then the first thing that might come to mind is where does that thing fall within our formula each of these line items having possibly multiple things that could contribute to them and then once we understand what line item something falls into then we can kind of visualize what's going to happen in that line item and then what's going to cascade through the rest of the formula when you look at income tax forms they are actually expanded on each of these line items in other words if you were to create an income tax form just from scratch at this point in time what you might do is just simply create page one the summary page which would basically be a formula such as this and then you would have sub schedules that would be expanding on each of those line items as needed that's not exactly how the tax code came about because it used to be that the tax code was very simple meaning you can most people can do their taxes on one side of a postage card sized piece of paper that was the idea was supposed to be very easy for most people to do their taxes but as things got complex they didn't want to add other forms instead they wanted to keep everything on one page or one form form 1040 so you ended up with multiple times of forms like a 1040 easy and so on and so forth because they were trying to make it so you just need one form that was like the selling point even though things were getting more complex and then they tried to simplify the code doing something like what we're doing at this point of time because these days you're not getting the actual forms from like the post office and filling them out by hand you're getting them from a computer so therefore having multiple pages isn't as big as a problem as it might have been before when you wanted a piece of paper that you can fill out just one line item so we'll touch more on that later when we get when we compare this to the actual tax form but for right now we've got the line items the first line item is income now income of course is kind of part of an income statement because we're talking about an income tax so the first half of the formula is an income statement although a strange one an income statement having income and then expenses now from a business perspective usually those expenses are the things that you had to consume in order to generate the income however when you're talking about individual income the income statement is more complex because the things that we spend money on are often personal the goal not being to generate income but to live well right so the expenses are going to get a little bit wonky on our income statement but the income line is pretty straightforward the irs basically saying everything is income unless we say otherwise is the general idea and we'll dive into that there's of course a lot of gray area then with the income statement what needs to be included in income what needs to not be included in income whenever someone has a question about you know money that they have received loans that have forgiven or something like that then those all those questions are about the income line item is that going to be included or excluded increasing or decreasing the income line item on the tax formula obviously for taxes income going up is actually bad because everything is flipped on its head for taxes taxes disincentivizing to income right so we so it's everything's backwards then we have the types of deductions now the deductions can be broken out to what you might used to be called like above the line deductions versus below the line deductions uh or you might call them these are like schedule one deductions because now they have the schedule thing or adjustments to income when you hear adjustments to income that's basically a deduction because it's a lowering the income line item it's just another word another again another phrase that you could use for these line items for the types of deductions the point is that these ones are separate than the itemized deductions and the standard deductions these are the ones that are more rare except that possibly like an ira deduction is is fairly common in this section but most deductions that you think of are going to be either the generic standard deduction or the things that are within the itemized deductions such as charitable deductions state tax deductions and things of that nature that gets us to a subtotal adjusted gross income or a g i so you can kind of think of this if you had an income statement that sells like that sells like manufacturing like a inventory i mean you have you you could have well you could also have returns and allowances on an income statement so income minus like the returns or something gives you the adjusted gross income or you could think of an income statement has an income and then the cost of goods sold the things if you sell inventory gets you that like that subtotal gross profit it's all getting you it's all going the same direction your income is going down from top to bottom of the income statement but there's these subtotals along the way this is one for basically the income tax return kind of income statement so we have the adjusted gross income a g i very important subtotal because most of the fave out phase outs that we talk about meaning as we look at deductions as we look at credits those being good things because they're kind of like expenses although credits are a little different we'll talk about in a second but uh as those as those things go higher as our income goes higher we might phase out those items they might we might lose them and it's not usually based on the top line income but on the a g i adjusted gross income so that's why that's a very important line item and then we have the greater of two types of deductions either the standard deduction or the itemized deduction now this is an area a few years ago there's been some back and forth to try to simplify the tax code and and so on and so forth and the idea of that would be one idea to simplify the tax code would be let's stop doing so much of this itemized deduction business because obviously the people that itemized are usually the more wealthy individuals who who have these other categories of deductions that we're trying to incentivize but are kind of outside you know the normal deductions there there are things where the government is trying to incentivize people to behave in certain ways like a charitable deduction is clear clearly trying to incentivize people to give to charity which is kind of which is a good thing but at the same time you would think that you know people i still kind of think people would give the charity without needing the charitable deduction and if people are not itemizing they still might be given to charity even though they're taking the standard you know deduction and possibly not getting a benefit on a tax return of of giving to charity and so on and so forth if you get a deduction for retirement plans then and you don't have to include that money in income or you get like an IRA above the line or adjustment to income deduction then that's incentivizing people to save for retirement which is good but again if we didn't have that deduction would people not save for retirement i kind of feel like you know we should be telling people the motive matters in terms of people's behavior right they should be doing things not just because they've been triggered to do it like slides you know the dog salivating when a bell rings or something like that they should be doing it because you know they're thinking about it and about retirement say that's a good idea to do that there's a difference right between those two things but anyway so the standard deduction is one that everyone gets right no matter what and that's usually going to be a lower income individuals that are going to be taking the standard deduction and then the item deduction is only if the itemized deductions are greater than the standard deductions would you take the itemized deduction why is that because deductions are good and you're going to get either one of these but not both and therefore you're only going to take the itemized deductions if they're larger than the standard deductions what are the itemized deductions that usually push people over the threshold to itemize rather than taking the standard usually things related to a home purchase such as the the interest mortgage interest and property taxes and then you can combine that with state taxes if you have substantial income taxes on the state side which are capped and limited to but but those are the things that usually might push people over now you have to be careful with that too because real estate agents as we'll talk about when we get there will emphasize that and say that well you need to buy a home in order to take advantage of the taxes but and that might be the case but you don't it's not as straightforward as that either because the standard deduction is significant so you don't so if you're paying interest on a mortgage just to get its tax deduction that might not be the best way to go because you still have to pay the interest on the more you still have to take out a massive loan which is usually a big thing for most for most people in order to get basically a deduction but we'll talk more about that later that gets you to the taxable income so taxable income this whole thing is basically the income statement side of things for the income tax formula income statements are income minus expense this has another pit stop income minus deductions which are kind of expenses which are going to be the above the line deductions pit stop along the way adjusted gross income and then the greater of standard deductions or or the itemized deductions now as we're thinking about this just realize that when we look at these kind of deductions what kind of deductions makes sense from an income tax perspective it would be those deductions you need in order to generate the income in other words if you're if we're dealing with an income tax we're taxing people as they generate the money we're not taxing their balance sheet we're not taxing the money that's already in the bank theoretically that already got taxed when they earned it we're taxing the money as it's going into the bank uh as as they are earning that money now if you talk to one person that had income up top and they made like a hundred thousand dollars but in order to generate that hundred thousand dollars they had to spend sixty thousand dollars or else they wouldn't have generated the one hundred thousand dollars that would be usually like a business expense that would be something you'd see in like a schedule c or something like that oftentimes but that's the conceptual business expenses make the most sense oftentimes well then it doesn't make sense to tax them on on a hundred thousand it makes sense to tax them on forty thousand because they had to expend sixty thousand in order to make the hundred thousand because if you compare that to somebody else that has a w two job for example and they make one hundred thousand but have no expenses they didn't need to spend anything in order to generate the one hundred thousand well it wouldn't make sense to tax both of them on the top line one hundred thousand it would make sense to tax people only on their net income deducting the expenses that were needed in order to generate the income right uh but obviously and so that's but obviously that gets complex because people are going to say well what kind of things were necessary to generate the income and that's why you end up with the standard deduction because the the code is basically saying we're not going to get into that we're just going to say we're going to say if you have a business it'll be on the schedule c and then everybody else just gets this standard deduction uh if it's not a business expense and that's what it's going to be and then of course because the tax code can never stay constant you get the itemized deductions as well which are usually things where the government is trying to adjust your behavior it's not about tax collection oftentimes with the itemized deductions it's more about how can they get you to do certain things well they get you to do things with the tax code if they if they want if they think that she that they want to stimulate the housing market then if they increase the deduction for interest on homes that's going to you know that's going to have a significant impact on behavior with regard to the housing market if they if the charitable deductions are good if they change the charitable deduction rules that's going to if they want people to save for retirement they can change the deductibility of putting money into an IRA or something their attempts to change your behavior and so you can argue whether or not the government should be in the business of trying to change your behavior or should they just stay out of your business and just focus on collecting whatever taxes they need to collect by simplifying the tax code and letting letting people make their own decisions about retirement contributing to charity and all that kind of stuff so that's a debate to have now notice you would think you'd be basically done if it was a flat tax you'd say okay there's taxable income i'm going to multiply that times the tax rate but as we saw before it's not a flat tax it's a tax uh it's a it's a progressive tax so now you have to calculate this based on you know tax tables oftentimes which are based on the tiered system that we talked about before and we could have some taxes that are outside of this that would be such as you know to qualify dividends or capital gains for example that so the taxes calculation actually gets quite complicated now what do we do from our data input side of things we usually input the income statement and kind of double check the taxable income possibly with another worksheet as we will do in excel in this formula standpoint comparing that to what we entered in the tax software with a tax forms uh type of calculation and then oftentimes we rely on the tax return or the tax software to do the tax calculation which is fine but we probably also want to have a conceptual idea of what the tax return is doing so we can communicate that to others so that we can make sure that there's not an error uh in the calculation and so that we can effectively plan uh going forward but just for the data input into the software we're basically going to double check this taxable income and then and then rely oftentimes on the software to do the tax calculation also note this is not accounting for a double entry accounting system there's no balance sheet here you can see for individual income taxes that means we're losing a huge internal control we're not using accounting software oftentimes some people do and that's going to give a high level a much more accurate level of assurance that your income statement is correct because the software is going to force you to use the double entry accounting system and you'll have a balance sheet and if you're doing bank reconciliations you have even a higher level of assurance but many times people don't right so that means and so what we're on the tax return side of things as as we do the as as we do the data input and notice by the way using software to use the double entry accounting system you can do that for personal books as well if you wanted to you can put your personal financials into the accounting software and use the double entry accounting system you know in a in a similar fashion that way but again on the form 1040 we're going to be driven by income and we're going to be driven by forms oftentimes w2 forms and so it is you know it kind of is what it is more complex tax returns you know the bookkeeping will be more important and then if you have business tax returns then of course uh it's the bookkeeping becomes more more important so that's going to be that's going to but so that means that when we do the data input we want to give a double check somehow so oftentimes what i would do and what i've seen i've worked at many cpa firms often many of them will have an outside calculation to kind of double check possibly in excel or some worksheet so that you can re-enter this information again into another system and double check that you come out to the same taxable income for both calculations and then we've got the tax before credits and other taxes so the tax being calculated again you would think that would be somewhat the end but no we also have credits now the credits are going to really complicate things because they're not part of the they're not like a deduction they're similar to deductions in that they're both good we like deductions we like credits but the credits are calculated are put in place after we actually calculated the tax therefore the credits are going to have a much larger impact from a dollar to dollar credit in other words if you had a one dollar credit versus a one dollar deduction the one dollar credit's going to be a much higher value given the fact that you're going to get the whole dollars worth of benefit as opposed to a dollar deduction which will simply decrease your taxable income and then you're only going to get a benefit based on whatever your tax rate is based on the progressive tax tables and all of that kind of stuff so so the credits are great from in that we want credits but when you try to think about what the impact is on the income tax formula credits are going to greatly complicate the whole the whole process here and then we have other taxes now we're talking here primarily we're talking about an income tax when we're looking at the form at 1040 but sometimes there's other taxes you know that could be in play here such as the self-employment tax is going to be one of the big ones because if you have a schedule c type of business then in taxable income you have your your income coming in from your business but the iris also wants their payroll tax equivalent from you who they see as basically the employee of your own business and therefore since you didn't give yourself a w2 and withhold payroll social security and medicare they're gonna they're gonna calculate uh self-employment tax which is basically payroll taxes for self-employed individuals calculating both the employee and the employer portion so if you have a business or are subject to self-employment tax that is a huge addition down here and will complicate things a lot so if you're a tax preparer you want to be thinking do i want to deal with businesses do i want to deal with tax returns that have business entities whether they be schedule c's flow through entities s corporations llc's or corporations partnerships flows do i want to deal with those or not if you do even with schedule c's it will complicate the tax return greatly so you might be saying hey look i just want to crank out as many returns as possible i'm not going to take on business returns and then i'll i'll focus on volume or you might say okay i know schedule c's are complex but i think i can take on basic schedule c's i don't want to go through i don't want to actually do the tax return to for flow through entities s corporations and partnerships and corporations which aren't a flow you know corporate tax returns because then you have to file an actual separate return or or possibly you you don't file the separate return you won't do the corporate return you'll just do the business return after the corporate return has been done by someone else right you might just say i only do the form 1040 individual income tax returns so so you really want to think about that because it's really difficult to tell clients no right then that's what you need to know what you want to do and what you don't want to do know what you know know what you don't know and don't let the client try to pressure you into taking on work that you're like i'm not that's not my thing i'm not doing that uh and which can be difficult so then we've got that'll give us the total tax and then we've got and then again you think you'd be done right here but you're not because now you've got the tax payments and uh refundable credits okay so first of all we have these credits we already saw the credits up top so you're like what i already dealt with the credits why are there another credits down here on this line item and that has to do with refundable credits versus non-refundable credits now a non-refundable credit is is what we used to think of as kind of a normal a normal credit meaning a tax by definition means that you either owe money or you don't owe money so when we talk about the income taxes then usually what we're trying to do is lower the amount of tax that we have to pay the money's only going one direction normally for a normal tax system it's going from us the earners of the money to the government that's the way it's going and if we get a credit or a deduction those are the two things that could lower the amount of money that's going from us to the government so taxes traditionally do not wind up in the money going from the government to us right you might say well there's a refund but normally traditionally the refund means the money went from us to the government but we paid we overpaid and therefore they are refunding the overpayment the refund isn't money that's going from the government to us they're not paying us just you know they're not that's traditionally what happens so so that would mean that the credits up top here are the types of credits that do not bring taxable income below zero because that wouldn't make any sense if you don't owe any tax uh if if if you if you're saying i don't have any tax to pay right here and then you had a credit which would be available to take if you had tax to pay but you don't have any tax to pay then then you're not going to get a benefit from the credit because the government doesn't pay you the money only goes one way it's a tax you pay the government or you don't pay the government however if it's a refundable credit that equation changes right so now you have situation where even if i don't owe any money the government gives me the government the money's going from the government to me right in those situations so so it's not a refund even though it's going to be qualified counted as a refund in that case it's more of a benefit or of a welfare type of program that's worked into the tax code and so so it complicates the tax system but a lot of people think that the tax system is the best way to deal with the safety net kind of issue so now we so now we have these breakout between the credits that don't take the tax below zero and the credits that do the ones that don't are called non-refundable the ones that do are refundable to make that even more complex some credits that are refundable have a refundable portion to them so we then have to determine what portion of the credit is refundable what portion is not then we have the payments now the tax system is set up so that the government does not want to allow you to wait till the end of the year so if we're talking about 2023 then you can't just simply pay all of your taxes when the tax return is due on april 15th let's say of 2024 it would already be late you would be hit with penalties and interest the government wants their money during the year why well one because they want the money as you earn it and there's time value related to money so they want it sooner rather than later and two they don't trust you to hold on to the money that you have earned during the year to be able to pay them at april 15th of the following year so they want to force you to pay them when the money is in your hand or even before it gets in your hand by making the employer the bad guy taking the money out of your paycheck before you get it so that means that the taxes are supposed to be the form 1040 should simply be a reporting requirement and not something that results in either a refund or money that is due meaning it would be similar to payroll taxes if you've dealt with payroll taxes they're the same concept in that you pay the taxes when you pay the employee you know you pay the taxes during the the pay periods and whatnot and then you file the form 941 usually on a quarterly basis as opposed to a yearly basis but the 941 is just a summary so you're just saying hey look this is how much payroll taxes i owed this is how much i already paid you therefore i don't have anything do and i don't have anything refunded normally that's the way the payroll tax works if the payroll tax is working correctly for the for the income tax you can't do that because it's too complex there's no way there's no way that you're going to get your withholdings correct exactly it's impossible because the tax code is too complex so what are you what are you going to do then well the whole system is set up so that you overpay so when you fill out your w4 to get withholdings on your wages the the whole system is set up generally to overpay and and that serves a couple purposes for the government number number one that means that they're more likely to get their money of course and and that also means that it's likely that you're going to get a refund at tax time because you have overpaid and that makes the government look good right so it looks like the bad guy is the employer who keeps taking your money out of your paycheck every every pay period that jerk and then the good guy is the government that gives you a refund on the on tax day there the the the government comes in and saves you like robin hood everything's flipped on its head i thought robin hood stole from the tax man and then gave to the back to the people that earn the money no it's the other way it's the other way according to the ira the tax man is robin hood and the okay but so that's so that's why you shoot for a refund you're shooting for a refund not because you just want a refund because you're shooting for a refund so you don't get hit with the stick and i'm going to repeat this multiple times what's the goal of income tax not to get hit with the government stick what is the government stick penalties and interest right hopefully beyond that jail time or whatever but generally the stick is penalties and interest they're going to hit you with that a lot of times before they before usually they go further than that right so so that's where so we're trying to overpay to avoid getting hit with the stick and that's what we do that's why we get a refund otherwise we would like to be exactly because what would happen then is we would get more of our money sooner meaning we'd get bigger paychecks if we lower our withholdings but if we increase our withholdings we're going to get smaller paychecks but we're less likely to get hit with penalties and interest at tax time the whole system is generally set up to overpay the taxes so that the IRS is more likely to get their money and be able to give you at least a small refund at tax time okay tax refund or tax due so that's going to get us then of course to whether or not you owe money or not which is going to be the bottom line for this tax period and then of course based on this information the tax calculation you then think about what's going to happen next year how do i how do i make sure next year's withholdings are sufficient so that i don't get hit with the stick of penalties and interest