Schematic Big Picture of the US Income Tax

It's easy to get lost in all the "trees" when wandering through the "forest" of income tax returns, so I have pasted above a helpful schematic giving the big picture of how our tax code works. (If you click or double-click on the image below, you will get a bigger and higher resolution picture.)

Yes, I know that TaxWise will do all this for you....but it is important that the software should not be a mysterious black box. I want each of you to understand the logic of what TaxWise is doing--so you don't get into the kind of trouble that Treasury Secretary Geithner got into.

You may want to print out a copy of the brand new form Form 1040, which is hot off the press and newly released by the IRS just yesterday, so that you can refer to it as I discuss the schematic above. I found printable copies of the final version of the Form 1040 here on the TaxProf blog. (Click on the images to blow them up so they are readable, and, if possible, print them out for reference and annotation.)

As you will soon realize, the Form 1040 is a two-page form we can view as the "master document" summarizing a taxpayer's entire situation. Our taxpayers will almost always have lots of attachments to that master document, but the Form 1040 itself really captures the basic logic of the taxpayers situation.

To my students: before reading below, see if you can identify the places on the front and back of the 1040 that correspond to the schematic above.

The top of the first page of Form 1040 has pretty straightforward basic information identifying the name and address of the taxpayer, spouse (if it's a joint return), filing status, and dependents, if any. (But don't be deceived--it can be tricky to figure out filing status and dependency status. Make sure you practice working through the logic of the flow charts in Tabs B and C of your trusty spiralbound Pub 4012.)

Lines 7 to 22 on the Form 1040 give the amounts of the different types of income that make up the Tax Base in the schematic above.

Lines 23 to 36 on the Form 1040 give the amounts of the different types of Above-the-line deductions. (The formal official name for above-the-line deductions is "Adjustments to Income.") As you will see, these turn out to be the best kind of deductions to have.

The bottom line on the front page of Form 1040 is Line 37, the Adjusted-Gross-Income (AGI), which is defined as the difference between the Tax Base "Total Income" on line 22 and the Adjustments to Income Total on line 36. As you will also see, AGI is a very important concept in our income tax system, because so many different tax benefits depend on having an AGI below certain critical cutoff levels.

Okay...that's it for the front page of Form 1040. Conceptually, it's all not all that bad. Add up a bunch of different types of income, then subtract a bunch of deductions to get AGI.

On to the back page of Form 1040.

The back page of the 1040 reminds me of that recurring line on those late-night infomercials: "But wait! There's more!" because the bed buffaloes on the back page seem to go on and on and on.

The first number on the back page is just a repeat of the bottom line on the first page: the AGI. That is, by definition, line 37 at the bottom of the first page equals line 38 at the top of the back page.

Now what next?

We subtract more stuff from AGI in order to reach Taxable Income on line 43.

Now what is it exactly that we are subtracting at this stage?

One thing we are subtracting is "The larger of Itemized Deductions or Standard Deductions (which you can find on line 40). (For the purposes of the Basic Exam you will take on the first day of class, you only need to know the details of the Standard Deduction. I will discuss Itemized Deductions later in the first week of class.) By the way, these are sometimes called "Below the line deductions" because they reduce taxable income but do not affect AGI.

The other we are subtracting at this stage are Exemptions, which is currently defined as $3,650 times the number of people the taxpayer can claim on the return (potentially, himself, a spouse if married filing jointly, and eligible dependents, if any.) Some taxpayers--and you may be one of them if you are a college student supported by your parents--are not eligible to claim any exemptions on their own tax return.

After we've done all that subtraction, we get Taxable Income on Line 43.

Now, time to compute the tax on Line 43. To help you understand what TaxWise is doing when it computes the tax on Line 43, I highly recommend looking at the tax tables on pages 7 though 9 of this IRS publication. As you can see, we currently apply a graduated set of rates ranging from 10% to 35% at this stage.

But wait! There's more!

The schematic chart refers to the "Alternative Minimum Tax, (AMT)" which we can--fortunately--ignore for the purposes of our VITA site. AMT is out of scope for VITA sites, and thanks to the legislation Congress passed last week, it is safe to assume that AMT will not apply to taxpayers with incomes low enough to qualify for VITA services.

But, wait, there's more!

We are not done yet!

Time to deal with Tax Credits, which subtract from a taxpayer's liability.

Tax credits come in two flavors: "non-refundable" and "refundable."

Nonrefundable credits, which you can find on Line 47 to 54 of the 1040, are called nonrefundable because they can only knock the taxpayer's liability down to zero--they can't make it negative. Thus, the lowest number you can get in Line 55 is zero.

But wait, there's more!

We need to give the taxpayer credit for any taxes he paid during the year, either through money withheld from his paycheck (Line 61) or paid as estimated taxes (Line 62).

And, wait, there's more!

We also need to take into account the refundable credits, which are very important to many low-income taxpayers. You will find those on Line 63 to 71. Those are the credits that give many of our taxpayers very large refunds. The most important of these credits for our taxpayers is the Earned Income Tax Credit, which is currently the biggest cash federal antipoverty program--and it is run through the tax code.

Now, we are done--the bottom line, the amount of refund or balance due is at the end of the page, right above the signature lines.

For many of my students, I expect this all seems about as clear as mud right now--there are many mysterious and inscrutable terms on these forms. Fortunately, most of the obscure items are irrelevant for VITA taxpayers, but there is still a good deal you need to learn as you get ready to take the certification tests.

I know it does feel like a foreign language right now. Please feel free to email me your questions, you can get advance class participation credit even before you get back to campus, and I will answer your questions in this blog.