Individual Tax Formula and Planning
The individual tax formula is a core topic on the TCP section of the CPA exam. You must understand the structure from gross income through tax liability, including all deductions, credits, and planning opportunities.
Individual Tax Formula
| Line | Item | Key Notes |
|---|
| 1 | Gross Income (IRC Section 61) | All income from whatever source derived unless specifically excluded |
| 2 | Less: Above-the-Line Deductions | Deductions FOR AGI (available regardless of itemizing) |
| 3 | = Adjusted Gross Income (AGI) | Key threshold for deduction limitations and credit phase-outs |
| 4 | Less: Greater of Standard or Itemized Deductions | Deductions FROM AGI |
| 5 | Less: Qualified Business Income Deduction (Section 199A) | Up to 20% of QBI from pass-through entities |
| 6 | = Taxable Income | Subject to graduated tax rates |
| 7 | Tax Liability (from rate tables) | Rates: 10%, 12%, 22%, 24%, 32%, 35%, 37% |
| 8 | Less: Credits | Dollar-for-dollar reduction (nonrefundable first, then refundable) |
| 9 | Plus: Other Taxes | Self-employment tax, AMT, NIIT (3.8%) |
| 10 | Less: Payments and Withholding | Estimated payments, W-2 withholding |
| 11 | = Tax Due or Refund | |
Common Income Exclusions
| Exclusion | IRC Section | Key Details |
|---|
| Gifts and inheritances | Section 102 | Gift tax paid by donor, not recipient; inheritance receives stepped-up basis |
| Life insurance proceeds | Section 101 | Lump sum death benefits excluded; interest on proceeds is taxable |
| Municipal bond interest | Section 103 | Excluded from federal tax; may be subject to AMT (private activity bonds) |
| Qualified scholarships | Section 117 | Tuition and required fees/books; room and board are taxable |
| Gain on sale of residence | Section 121 | Up to $250K single/$500K MFJ; must own and occupy 2 of last 5 years |
| Employer health insurance | Section 106 | Premiums paid by employer excluded from employee's income |
Above-the-Line Deductions (FOR AGI)
- One-half of self-employment tax (Section 164(f))
- Self-employed health insurance premiums (100%)
- IRA contributions (subject to AGI phase-outs if covered by employer plan)
- Student loan interest (up to $2,500; AGI phase-out applies)
- HSA contributions
- Educator expenses (up to $300)
- Alimony paid (pre-2019 agreements only)
Key Tax Credits
| Credit | Max Amount | Refundable? | Key Rules |
|---|
| Child Tax Credit | $2,000/child under 17 | Partially | Phase-out begins at $200K single / $400K MFJ |
| American Opportunity | $2,500/student | 40% refundable | First 4 years of higher education; at least half-time enrollment |
| Lifetime Learning | $2,000/return | No | Any postsecondary education; no enrollment requirement |
| Earned Income Credit | Varies | Fully | Low-to-moderate income; investment income limit applies |
| Child/Dependent Care | $1,050-$2,100 | No | 20-35% of up to $3K/$6K expenses; both spouses must work |
Tax Planning Strategies
- Timing of income and deductions: Defer income or accelerate deductions to reduce current-year liability
- Maximize retirement contributions: 401(k), IRA, HSA reduce taxable income
- Harvest capital losses: Offset gains; deduct up to $3,000 of net losses against ordinary income
- Charitable giving: Donate appreciated property to avoid capital gains and receive FMV deduction
- Roth conversion: Convert traditional IRA to Roth in low-income years; pay tax now for tax-free growth
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