Adjusted Gross Income
Why adjusted gross income? Wouldn’t gross income be a good enough yardstick or reference point for determining tax in the Federal Income Tax Equation?
(Note: The Federal Income Tax Equation is defined as Tax Due or Refund = Gross Income - Above the Line Deductions [a category that for the most part is limited to the expenses of producing Gross Income but also includes expenses that aren't related to the production of income such as alimony and interest on education loans] = Adjusted Gross Income - Personal and Dependency Exemptions - Below the Line Deductions [the choice between the standard deduction or itemized deductions] = Taxable Income x Federal Income Tax Rate - Tax Credits.)
The answer is that adjusted gross income (AGI) takes into account the expenses of generating gross income and avoids making the federal income tax a tax on gross receipts. Indeed, one could even say that a strong logic of fairness undergirds the role of AGI in the federal tax system: in the Federal Income Tax Equation as applied to Form 1040 U.S. Individual Income Tax Return (pdf file), taxable income is based not on gross receipts but rather on what is left after business owners (or individuals engaged in profit-seeking activity) subtract the ordinary and necessary (read: reasonable and customary) business expenses of producing gross income. (Please note this article does not consider the Federal Income Tax Equation as applied to Form 1120 U.S. Corporation Income Tax Return, Form 1120S U.S. Income Tax Return for an S Corporation, or Form 1065 U.S. Return of Partnership Income.) To be taxed on gross income without allowance for advertising, car and truck expenses, depreciation, property taxes, rent, utilities, wages, and other business-related expenses as detailed on Schedule C Profit or Loss From Business (Sole Proprietorship) (pdf file) would destroy the prospects of a positive cash flow for most sole proprietorships, especially when they must also pay their (employers’) share of FICA taxes. Adjusted gross income is thus a net concept and also a benchmark for calculating itemized deductions.
It is also important to distinguish between deductions taken above the line and deductions taken below the line. Above the line deductions, since they are used to determine AGI, are not subject to an AGI floor or the threshold of the standard deduction; in short, they are allowed in full. On the other hand, below the line deductions (also known as itemized deductions) are only allowed to the extent they, in toto, exceed the standard deduction. Moreover, medical and dental expenses (pdf file) and miscellaneous itemized deductions (pdf file) are subject to a further restriction in that they must exceed a floor amount expressed as a percentage of AGI (in 2007, 2% of AGI for miscellaneous itemized deductions and 7.5% of AGI for medical and dental expenses). If, for example, taxpayer’s AGI is $50,000 for 2007 and he or she has medical and dental expenses of $10,000 only $6,250 of these expenses qualify for deduction after subtracting the floor amount of $3,750 (7.5% of $50,000 AGI). If our taxpayer is single it would make sense to itemize since medical and dental expenses alone, even after subtracting the AGI floor amount, exceed the standard deduction of $5,350 for single filers.
Additional resources on the topic of adjusted gross income are listed below:
- How Rebates Would Phase Out
- 2007 Adjusted Gross Income (AGI)
- $100,000 Adjusted Gross Income Restriction Applies to Roth 401(k) to Roth IRA Rollovers in 2008 and 2009
- Adjusted Gross Income
- What’s your AGI?
Many happy returns, Roger