©2003 south-western college publishing, cincinnati, ohio chapter 6 credits and special taxes

©2003 South-Western College Publishing, Cincinnati, Ohio©2003 South-Western College Publishing, Cincinnati, Ohio©2003 South-Western College Publishing, Cincinnati, Ohio©2003 South-Western College Publishing, Cincinnati, Ohio

CHAPTER 6

Credits and Special TaxesCredits and Special Taxes

© 2003 South-Western College Publishing Transparency 6-2

Objective

Know the difference between deductions and credits


Credits and Deductions

A credit is a direct reduction in tax liability Credits are used to target certain groups for

tax benefit

A deduction is a reduction of taxable income and only an indirect reduction in tax liability


Illustration of difference between a $1,500 deduction and a $1,500 credit

Deduction CreditAGI $ 70,000 $ 70,000

Deduction (1,500) -0-

TI $ 68,500 $ 70,000

Tax Liability $ 13,620 $ 14,070

Credit -0- (1,500)

Tax due $ 13,620 $ 12,570

*This is assuming a single taxpayer in the 30% tax bracket

Tax Credits


Objective

Be able to calculate several common tax credits


Elderly/Disabled Credit (Schedule R)Provides tax relief for those not adequately covered by

Social Security Targets taxpayers > 65, or < 65 with total disabilityThis credit rarely shows up - qualifying is very difficult


Elderly/Disabled Credit - CalculationsFor Single, or MFJ with only one > 65

Credit base = {$5,000 - nontaxable SS benefits - .50 [AGI - $7,500 (single) or $10,000 (married)]}

Credit = Base X 15%

For MFJ with both > 65 Credit base = {$7,500 - nontaxable SS benefits

- .50(AGI - $10,000)} Credit = Base X 15%


Sue is single, 68, and has Dividend income = $ 150

Schedule E income = $4,400

Nontaxable SS = $3,200

Wages = $2,000

Calculations for single taxpayer:Base = $5,000 - $3,200 - .50($6,550 - $7,500) = $5,000 - $3,200 - $0 = $1,800

Credit = $1,800 X 15% = $270

This credit is reported on page 2 of Form 1040

Elderly Credit Example


Elderly Credit Example 2Wayne and Tammy are both 65 years old and file a joint return. AGI = $11,000 and they also receive nontaxable social security payments of $3,000 during the current year.

Calculations for MFJ, two > 65:Base = $7,500 - $3,000 - .50($11,000 - $10,000) = $7,500 - $3,000 - $500

= $4,000

Elderly tax credit = 15% X $4,000 = $ 600

The $600 credit is allowed only to the extent that Wayne and Tammy have actual income tax due before credits, so if their total tax due = $400, the $600 credit is really only worth $400 netting them a $0 balance due.


Child Tax CreditProvides tax relief through a nonrefundable

credit to taxpayers with children Taxpayer receives credit for each child under age 17

claimed as a dependent

Credit is $600 per child Credit phased out when AGI > $110,000 (MFJ); >

$75,000 (HH, S); or AGI > $55,000 (MFS) Reduction = $50[(AGI - threshold)/1,000]

If have 3+ children may calculate differently on Form 8812


Child Tax Credit ExampleTaxpayers have children ages 19, 10, and 3. Their AGI is $113,200. What is their Child Tax Credit?

•Have only two qualifying children

•AGI exceeds threshold, therefore must figure phase-out

($113,200 - $110,000) / $1,000 = 3.2

Round to 4 X $50 = $200 reduction

•Credit = ($600 X 2) - $200 = $1,000


Earned Income Credit (Schedule EIC) Refundable credit originally designed for working

parents (although now can also get if fairly low income with no kids)

Qualify if Between ages 25 and 65 with no children Any age with one child Married taxpayers must file MFJ

Earned income defined as: Wages plus deferred compensation

Self Employment income Meals/lodging provided by employer


Earned Income Credit (Continued)

Qualifying child (for EIC purposes)

Relationship test: (child, descendant of child, stepchild, foster child, or adopted child)

Residency test: Live more than 50% of year at taxpayer’s home

Fulltime students can live away from home

Foster children must reside all year

Age test: Under 19 (or 24 if FT student) or totally disabled at end of tax year


To Calculate EIC

Use EIC tables to calculate or ask IRS to figure for you on Schedule EIC

EIC is reported on page 2 of 1040 What is different about how this credit is reported

on the 1040 compared to other credits?It is refundable and therefore more like a “payment” than

a credit


Child and Dependent Care Credit (Form 2441) Gives tax relief to working parents who must provide

childcare for dependents Dependent must be under age 13 or Spouse or dependent who cannot care for themselves

Calculation Determine qualifying care costs: limited to the lesser of

Earned income of lowest earning spouse, or$2,400 (for 1 dependent) or $4,800 (for 2 or more dependents) If spouse is FT student, count him/her as earning $200/month (1 child)

or $400/month (2+ children)Must reduce by any amount reimbursed by employer

Multiply costs by a percentage that decreases from 30% down to 20% based on AGI (Table 1 in book)


Joanne has salary of $18,400 and investment income of $2,100. Lou is a full-time student. They have 3 children and total daycare costs of $5,800. What is their Child Care Credit?

Qualifying costs are the lesser of:Her earned income $18,400His earned income $ 4,800 (imputed at $400 / month) Daycare bill $ 5,800

Multiply by % from Table 1:$4,800 x 24% = $1,152 credit

What if Lou works part time, earning $3,000, and Joanne received $2,200 of employer-provided dependent care assistance?

Qualifying costs would be lesser of:Net daycare bill $5,800 - $2,200 = $3,600Lou’s earnings $3,000

Multiply by % based on new AGI: $3,000 x .23 = $690 credit

Dependent Care Credit Examples


Education Credits: Hope Credit Provides tax relief for higher education expenses (tuition

and fees) net of scholarship or reimbursement Available for each eligible student in first 2 years of

college Eligible students are taxpayer, spouse or eligible dependent Student must be 1/2 time and not had felony conviction for

possessing or distributing a controlled substance

Credit = 100% of first $1,000 + (50% of the next $1,000) Maximum credit = $1,500 Phased out when AGI > $41,000 (S) or $82,000 (MFJ)

MFS do not qualify


Education Credits: Lifetime Learning Credit (LLC) Provides tax relief for higher education expenses

(tuition and fees) net of scholarship or reimbursement Credit = 20% of first $5,000

Maximum credit = $1,000 per year Subject to same phase outs as Hope Credit and MFS do not

qualify

LLC can be used for part time students Not limited to first two years

Graduate school expenses qualify No limit on number of years you may claim LLC


How do LLC, Hope Credit and Educational IRAs Work Together?

For each student, taxpayer can get only one of the credits or a tax-free withdrawal from an EIRA Can claim Hope for first two years of student’s school and

then LLC in later years If taxpayer pays for more than one student in same year,

may take Hope for one student and LLC for another

Only the person claiming the exemption can claim a credit If parent cannot claim child as dependent, only the child can

claim education credit (who may lose it because of insufficient tax liability)


Education Credits -ExampleDave and Val (MFJ) claim 2 dependent children and have AGI of $72,000. Sean is a senior at NJSU. His tuition is $2,200. Corey is a freshman at Tulane. Her tuition is $19,200.

Calculation

Sean only qualifies for LLC because of his senior status. (20%)($2,200) = $440

Corey, a freshman, qualifies for the Hope Credit.

(100%)($1,000) + (50%)($1,000) = $1,500


Foreign Tax Credit (Form 1116)Provides relief from double taxation on money

generated from foreign sources Taxpayers pay foreign and U.S. tax on all income and

then take credit up to amount paid foreign governments

Credit = actual amount paid, but limited to: Net foreign income

Total U.S. taxable income

Thus, may not get full credit Can carryback 2 years and forward 5 years

X U.S. Tax Liability before the credit


Foreign Tax Credit Example

Joe Steele had $200,000 income from US and $100,000 income from employment in Kuwait. He paid $40,000 in Kuwaiti taxes. His US tax liability on $300,000 is $88,313.

CalculateMaximum Foreign Tax Credit is the $40,000 paid, but limited to:

($100,000/$300,000) x $88,313 = $29,438

Carry back or forward the difference: ($40,000 - $29,438) = $10,562


Work Credits

Welfare-To-Work Credit (for employers) Amount:

Up to 35% of $10,000 wages for 1st year credit Up to 50% of $10,000 wages in 2nd year credit

Employees must be designated as a long term assistance candidate

Credit may be taken for each qualified employee Must reduce wage expense by amount of credit

taken


Work Opportunity Credit (for employers) Credit = 40% of first $6,000 of wages

Reduced to 25 % if employee performs < 400 hours of service

Not allowed for employees who perform < 120 hours

Employees must be hired from high risk groups (felons, welfare recipients, underemployed youth, veterans, etc.)

Must reduce wage expense by amount of credit taken

Work Credits


Disabled Access Credit

For employers Provides relief for small businesses complying with 1990

ADA mandated structural requirements Available only to existing businesses with $1M or less in sales and 30

or fewer employees)

Credit = (50%) x (amount spent - $250) Maximum amount eligible is $10,250; therefore, maximum credit is

$5,000 Must reduce depreciable basis of asset by amount of credit

Example: Qualifying business builds a ramp for cost of $16,000. Credit = ($10,250 - 250) x (50%) = $5,000


Adoption Credit (Form 8839)

Provides relief to taxpayers who pay adoption expenses Credit is amount spent up to $10,000 per adoption

Adoption credit phases out at AGI > $150,000 Different rules if pay expenses over more than 1 year or if foreign

adoption If employer helps employee with adoption expenses, this benefit is

excludable from W-2 up to $10,000

Qualified adoption expenses include court costs, legal fees, travel, etc.

May claim adoption credit and adoption exclusion for same adoption, but cannot claim both and exclusion for the same expense


Objective

Have a general understanding of the Alternative Minimum

Tax Calculations


Alternative Minimum Tax (Form 6251) Tax was originally intended for high income

taxpayers with many shelters; it has evolved to impact many middle income people

Separate system for calculating taxes If Alternative Minimum Tax (AMT) is higher than regular

federal tax liability, must pay AMT amount

AMT Rates 26% up to $175,000 ($87,500 MFS) Alternative Minimum

Taxable Income (AMTI) 28% above $175,000 ($87,500 MFS) AMTI Long-term capital gains taxed at preferential rates


Calculation of Alternative Minimum Taxable Income (AMTI)

Taxable Income (from 1040)

+/- Adjustments

+ Tax Preferences

- AMT Exemption

AMTI

AMTI x rate = Alternative Minimum Tax

Alternative Minimum Tax


Alternative Minimum Tax Adjustments

Examples of negative adjustments (subtract from TI) State income tax refunds AMT NOL

Examples of positive or negative adjustments NOL Some passive losses Difference in regular depreciation and AMT depreciation Exemptions Most itemized deductions except:

mortgage interest contributions investment interest casualty losses gambling losses


Alternative Minimum Tax (continued)

Examples of Tax Preference Items Excess depreciation on real estate over straight line Excess depletion over cost, intangible drilling costs Tax exempt interest on private activity bonds (municipal

bonds issued to further a non-governmental activity - like an industrial park)

AMT Exemption Amounts $49,000 (MFJ); $24,500 (MFS); $35,750 (Others) Exemption is reduced by $.25 for each dollar of AMTI over

phase-out amount$150,000 (MFJ), $75,000 (MFS), $112,500 (Others)


Ralph and Lana (MFJ) report the following on their Form 1040:

Gross income:Salary $ 70,000Dividends/Interest 10,000Schedule C income 30,000 40,000

AGI $110,000Itemized Deductions:

Real Estate taxes $10,000Mortgage interest 18,000Non cash contributions 8,000 ( 36,000)

Exemptions ($3,000 X 2) ( 6,000)Taxable Income $ 68,000Regular Tax $ 11,730

AMT Example


AMT CalculationTI from Form 1040 $ 68,000Add back positive adjustments:

Exemptions 6,000Real Estate Taxes 10,000

Subtract negative adjustment (none) 0Add back tax preference items (none) 0AMTI $ 84,000AMT Exemption (49,000) $ 35,000AMT tax rate x 26%Alternative Minimum Tax $ 9,100

AMT Example


Objective

Understand the rules for computing tax on the unearned

income of minor children


Unearned Income of Minor ChildrenProvision designed to prevent parents from

transferring income-producing assets to children in lower tax brackets Net unearned income of child under age 14 must

be taxed at the parent’s highest tax rateNUI = Unearned income - (greater of $750 or Investment

expenses) - $750


Tax for Children under age 14 “Kiddie Tax” (8615)

Must use Form 8615 if child is under 14, has investment income > $1,500 and also has capital gains or earned income

If child is under 14 and has only interest/dividends with income between $750 and $7,500, parents may report the income on their return using Form 8814 (rather than file return for child) If parents file Form 8814

Take standard deduction of $750 for each childPay 15% on next $750The remainder is reported on parent’s 1040 as “other income”


Parents Election to Report Child’s Interest/Dividends - (8814)Reporting income on child’s tax return

No personal exemption allowed Standard deduction is the greater of earned

income or $750as limited by “regular” standard deduction

The tax on the net unearned income (such as dividends, interest, capital gains) of a child under age 14 is figured by using the parent’s highest marginal tax rate


Objective

Know the different rules for married taxpayers residing in

community property states


Community Property and Taxation Nine states - AZ, CA, ID, LA, NV, NM, TX, WA, WI -

follow the community property system Assumes that all property is either separate or

community Separate: acquired before marriage (or acquired through gift or

inheritance after marriage) Community: acquired after marriage

2 approaches Income from all property is taxed as community property (LA, ID,

TX) Income from separate property is taxed as separate property

(other 6 states)


That’s all!

©2003 south-western college publishing, cincinnati, ohio chapter 6 credits and special taxes

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