Question

Aurora received a $25,000 bonus computed as a percentage of profits. In 2016, Aurora’s employer determined that the 2015 profits had been incorrectly computed, and Aurora had to refund the $8,000 in 2016. Assume that Aurora was in the 35% tax bracket in 2015 but in the 15% bracket in 2016.

a. In 2015, how much is Aurora required to include in income?

b. In 2016, what is the amount of the deduction Aurora can claim? What is the reduction in taxes for 2016 as a result of the deduction?

Answer 1

A) gross income includes wages, tips, bonuses, overtime pay and reimbursements. So Aurora had to include the $25,000 in her gross income in 2015.

B) Since Aurora had to pay 35% taxes on the complete 25,000, she can claim a deduction equivalent to 35% of $8,000 = $2,800. Therefore, Aurora's taxes will be reduced by $2,800 in 2016.

Individuals pay income taxes depending on their marginal tax rate, that is probably why the $25,000 raised Aurora's tax bracket to 35% from a lower tax bracket. So when she claims a deduction she must calculate it based on her marginal tax rate of the previous year (35%).