CCH Federal Taxation Basic Principles Chapter 9 Tax Credits, Prepayments, and Special Methods ©2003, CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL

CCH Federal TaxationBasic Principles

Chapter 9

Tax Credits, Prepayments, and Special Methods

©2003, CCH INCORPORATED4025 W. Peterson Ave.Chicago, IL 60646-6085800 248 3248http://tax.cchgroup.com

CCH Federal Taxation Basic Principles 2 of 46

Chapter 9 Exhibits 1. Household and Dependent Care Credit 2. Elderly and Disabled Persons Credit 3. Adoption Assistance Credit 4. Child Tax Credit 5. Hope and Lifetime Learning Credits—Overview 6. Hope and Lifetime Learning Credits—Phaseout Rules 7. Hope and Lifetime Learning Credits—Examples 8. General Business Credits—Overall Limit 9. Earned Income Credit—Overview10. Earned Income Credit—Computations11. Obtaining Credit for Excess Withholdings12. Estimated Tax Payments—Overview13. Estimating Taxes—Example14. Alternative Minimum Tax—History15. Nonrefundable Credits

Chapter 9, Exhibit Contents


Household and Dependent Care Credit

Qualifying individual. A qualifying individual can be a child under age 13, or a mentally or physically handicapped dependent or spouse.

“Gainful employment” expenses. Gainful employment expenses include household services such as babysitting, housekeeping, and nursing. Outside services, such as daycare facilities, must be in qualified facilities. These expenses must be incurred to enable the taxpayer to be employed or to seek employment.

Chapter 9, Exhibit 1a


The formula for computing qualifying expenses is as follows: 35% x the lesser of (a), (b), or (c) Where:

a = actual gainful employment expenses b = $3,000 per qualifying individual, not to exceed $6,000c = earned income (if married, use income of the spouse with the lower income)


Chapter 9, Exhibit 1b


The maximum expenses eligible for the credit must be reduced by amounts excludable from income under an employer-provided dependent care assistance program.

Credit percentage. The credit percentage is the greater of 35%, reduced by 1 percentage point for each $2,000 of

adjusted gross income, or fraction thereof, above $15,000 or 20%


Chapter 9, Exhibit 1c


Household and Dependent Care Credit—Example

QUESTION: How much of the dependent care credit may be applied against their tax liability?

FACTS: Billy and Lynda are married taxpayers filing a joint return with three dependents ages 2, 5, and 14. They incurred employment-related childcare expenses in the amounts of $2,000, $5,000 and $14,000 respectively. Lynda worked part time and had earnings of $3,000. Billy had earnings of $97,000.

SOLUTION: Credit allowed is $600 ($3,000 qualified expenses x 20% credit percentage)Qualifying expenses of $3,000 are the lesser of: a = $7,000 actual gainful employment expenses ($2,000 + $5,000) b = $6,000 (i.e., $3,000 each for the 2- and 5-year-old) c = $3,000 earned income of the spouse with the lower incomeCredit percentage is the greater of: (a) 0% = 35% – [($100,000 AGI – $15,000 threshold amount)

$2,000], expressed as a % (b) 20% (minimum credit percentage)

Chapter 9, Exhibit 1d


Eligible taxpayers. Eligible taxpayers must meet one of the following two conditions:

1. Reach age 65 before the end of the tax year 2. Retire under age 65 before the end of the tax year due to total,

permanent disability. Married taxpayers. Married taxpayers must file jointly unless they have lived apart for the entire year.

Elderly and Disabled Persons Credit



Elderly and Disabled Persons Credit

The formula for computing the credit is as follows:

15% x [(a) – (b) – (c)]

Where:

a = Base amount of $5,000 (or $7,500 for married filing joint return with both spouses age 65 or older)

b = Tax-exempt pension benefits such as tax-exempt Social Security benefits

c = Income level adjustment: 50% x (AGI – $10,000) for married persons filing jointly 50% x (AGI – $ 7,500) for single persons 50% x (AGI – $5,000) for married persons filing separately



Elderly and Disabled Persons Credit–Example

FACTS: Larry, age 67, and Donna, age 62, report $12,000 adjusted gross income on their joint return. In addition, they receive $1,500 nontaxable Social Security benefits.

QUESTION: How much of the elderly credit may be applied against their tax liability?

SOLUTION: Credit allowed is $375 (15% x ($5,000 – $1,500 – $1,000))

a = Maximum base amount $5,000

b = Nontaxable Social Security benefits $1,500

c = Income level adjustment $1,000 1,000 = (50% x ($12,000 AGI – $10,000)) for married persons filing jointly



Adoption Assistance CreditTaxpayers who adopt an eligible adoptee may claim a tax credit for qualified adoption expenses of up to $10,160 for each eligible adoptee.

If adoption expenses are paid through a nondiscriminatory employer adoption assistance program, which may be part of a cafeteria plan, the expenses paid by the employer may be excluded up to the limits stated above.



Qualifying adoptee. The adoptee must be a child under

age 18 or a child with special needs.

Special needs adoptee. A special needs adoptee is a child who, according to a state determination, could not be returned to the home of his or her birth parents because of a specific condition (e.g., a medical condition, a physical or emotional handicap).

Adoption Assistance Credit




Qualified expenses. These include adoption fees, court costs, attorney fees, and other expense related to the legal adoption of an eligible child. Expenses incurred in carrying out any surrogate parenting arrangement do not qualify.



Phaseout of credits and exclusions. For all filing statuses, the adoption assistance credit phases out at the following modified AGI (i.e., AGI figured without certain foreign and possessions income exclusions).

Ceiling of $192,390 modified AGI Floor of $152,390 modified AGI Phaseout range of $40,000 (ceiling minus floor)




Adoption Assistance Credit—Example

QUESTION: How much of the $10,160 adoption assistance credit may be applied against their tax liability?

FACTS: A married couple incurs $20,000 in adoption expenses for a child under the age of 18. Their modified AGI is $167,390.

SOLUTION: $6,350 = $10,160 – $3,810 phaseout amount Where: $3,810 = $10,160 x [($167,390 – $152,390) $40,000]

Chapter 9, Exhibit 3e


Child Tax Credit

Taxpayers with one or more “qualifying children” are allowed a

credit of $600 per child.

Qualifying child. The “qualifying child” must be

A son or daughter for whom the taxpayer may claim a dependency exemption (i.e., natural, step, adopted, or foster pending adoption) and

Less than 17 years old at the close of the tax year.



Child Tax Credit

Phaseout of child tax credit. The total amount of credits is reduced $50 for each $1,000, or fraction thereof, of modified AGI above the following threshold levels:

Filing Status Threshold for Modified AGI:

Single, head of household,surviving spouse

$ 75,000

Married filing jointly $110,000

Married filing separately $ 55,000



Child Tax CreditFACTS: A married couple has five dependent children whose ages at the end of the year are 5, 10, 12, 15, and 17. Modified AGI is $112,100.

QUESTION: How much of the child tax credit can be applied against their tax liability?

SOLUTION:

a Number of qualifying children 4

b = (a x $500) Child tax credits before phaseout (4 x $600) $2,400

c Modified AGI $112,100

d Threshold amount $110,000

e = (c – d) Excess modified AGI $2,100

f = e rounded up Excess modified AGI, rounded up to the next thousand $3,000

g = (f $1,000) Number of increments ($3,000 $1,000) 3

h = (g x $50) Phaseout of child tax credit (3 x $50) $150

i = (b – h) Child tax credit after phaseout $2,250(If the couple’s tax liability did not exceed $2,250, the child tax credit would be limited to the actual tax liability.)



Hope and Lifetime Learning Credits—Overview

Hope Scholarship Credit. The Hope Scholarship Credit provides a maximum nonrefundable tax credit of $1,500 per student for the first two completed years of postsecondary (i.e., undergraduate) education. The $1,500 per student limitation is computed as follows:

a + b Where:

a = 100% of the first $1,000 of qualified expenses b = 50% of the next $1,000 of qualified expenses.



Lifetime Learning Credit. The Lifetime Learning Credit allows a maximum nonrefundable tax credit of $1,000 per taxpayer for an unlimited number of years if qualified tuition expenses are paid after June 30, 1998, and in a year in which the Hope Scholarship Credit is not

claimed for a given student.

The $1,000 limitation is computed as follows:20% of the first $10,000 of qualified expenses ($5,000 before 2003).




Qualified Students. Qualified students consist of the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependents.

Hope Scholarship Credit. To qualify, a student must carry at least one-half the normal full-time workload for the course of study the student is pursuing.

Lifetime Learning Credit. A student qualifies even if he or she carries less than one-half the normal full-time workload. Also, the Lifetime Learning Credit, but NOT the Hope Scholarship Credit, is available even if students have completed their first two years of undergraduate education.

The Hope credit is denied if a student has been convicted of a federal or state felony drug offense.




Qualified expenses. Qualified expenses include tuition and fees but NOT books, room and board, student activity fees, insurance expenses, or athletic fees.

Qualified programs. The Hope Scholarship Credit is not allowed for the expenses of any graduate or advanced degree programs. However, the Lifetime Learning Credit is allowed for the expenses of any undergraduate, graduate, or vocational program.




Qualified time frame. The Hope Scholarship Credit is allowed for a tax year if the student has not completed (before the beginning of the tax year) the first two years of postsecondary education at an eligible educational institution.

Chapter 9, Exhibit 5e



Hope and Lifetime Learning Credits—Phaseout Rules

Phaseout of Hope and Lifetime Learning Credits. The sum of Hope Scholarship Credits and Lifetime Learning Credits phase out at the following thresholds for modified AGIs.

Filing Status Threshold for Modified AGI

Floor Ceiling Phaseout Range

Single, head of household, surviving spouse

$41,000 $51,000 $10,000

Married filing jointly $83,000 $103,000 $20,000

Married filing separately N/A N/A N/A

Chapter 9, Exhibit 6


FACTS: A married couple has three dependent children in college. The sum of the Hope Scholarship Credit and Lifetime Learning Credit before phaseout is $5,000.

QUESTION: If the couple’s modified AGI is $89,000, how much of the credits may be applied against their tax liability?

SOLUTION:

Example on Phase-Out of Hope/Lifetime Credits

a Hope and Lifetime Credits before phaseout $4,000

b Modified AGI $89,000

c Threshold amount, floor $83,000

d = (b – c) Excess modified AGI $6,000

e Phaseout range $20,000

f = (d e) Phaseout percentage ($6,000 $20,000) 30%

g = (a x f) Phaseout amount ($5,000 x 30%) $1,500

h = (a – g) Allowable tax credit ($5,000 – $1,500) $3,500

(If the couple’s tax liability did not exceed $3,500, the tax credit would be limited to the actual tax liability.)

Hope and Lifetime Learning Credits—Example 1



FACTS. Ken and Barbie have modified AGI under $83,000. Their daughter Kristi, begins college at State University in September, 20x1. Kristi, a promising writer, receives a scholarship that reduces her parents’ tuition bill to $1,300 per semester. The table below shows Ken and Barbie’s payment schedule as well as years of eligibility for the Hope credit:

Payment Date: Semester Begins: # Years Completed Before Beginning of Tax Year

Eligible for Hope Credit? (i.e., eligible if the first two years of postsecondary education have not been completed, before the beginning of the

tax year)

Jul. 20, 20x1 Sep. 5, 20x1 0 Yes for 20x1

Jan. 02, 20x2 Jan. 5, 20x2 ½ Yes for 20x2

Aug. 15, 20x2 Sep. 5, 20x2

Dec. 15, 20x2 Jan. 5, 20x3 1 ½ Yes for 20x3

Aug. 15, 20x3 Sep. 5, 20x3

Dec. 15, 20x3 Jan. 5, 20x4 2 ½ No for 20x4

Aug. 15, 20x4 Sep. 5, 20x4

Dec. 15, 20x4 Jan. 5, 20x4 3 ½ No for 20x4

Aug. 15, 20x4 Sep. 5, 20x4

QUESTION: For the years 20x1 – 20x2, determine the amount of Hope and Lifetime credits under the following three assumptions:

1. The Hope credit is taken in 20x1 and 20x2; the Lifetime credit thereafter.

2. The Hope credit is taken in 20x2 and 20x3; the Lifetime credit is taken in 20x1 and after 20x3.

3. Same as assumption 1 except that the January 2, 20x2 payment is made two days earlier on December 31, 20x1.




SOLUTION:

Assumption 1 Assumption 2 Assumption 3

Tax

Year

Tuition

Paid

Credits

Tuition

Credits

Tuition

Credits

Hope Lifetime Hope Lifetime Hope Lifetime

20x1 $1,300 $1,150 $ 1,300 $ 2,600 $ 1,500

20x2 3,900 1,500 3,900 $ 1,500 2,600 1,500

20x3 2,600 $ 520 2,600 1,500 2,600 $ 520

20x4 2,600 520 2,600 $ 520 2,600 520

20x4 1,300 260 1,300 260 1,300 260

Total Credits $ 3,950 $ 4,040 $ 4,300

Tax Planning. In order to use the maximum credit in the earliest tax years possible, a student who enters college in the fall and is not going to incur sufficient first-semester tuition expenses to use the full $1,500 credit for that year should be sure to pay second-semester tuition expenses before January 1 of the following year. By paying for two semesters in the first year, a student can maximize the credit in the first calendar year (while receiving only one semester of instruction).




General business credits (GBCs) are a set of several credits commonly available to business. The GBCs include credits for investment, research, targeted jobs, and disabled access. Overall limit. General business credits are limited to:

Net income tax – the greater of (a) or (b)

Where: a = The tentative minimum tax b = 25% of net regular tax over $25,000

General Business Credits—Overall Limit



Net income tax. The sum of regular income tax and alternative minimum tax liability reduced by nonrefundable credits other than GBCs.

Tentative minimum tax. An amount used in computing the alternative minimum tax.

Net regular tax. The taxpayer’s income tax liability reduced by nonrefundable credits other than GBCs, but without regard to the alternative minimum tax.




Individual business credit limits. The dollars that can be claimed under each of the individual business credits comprising the GBCs must be determined separately under each credit’s own rules.




Earned Income Credit—Overview

A refundable tax credit is provided for low-income workers with or without qualifying children.




Eligible taxpayers without qualifying children. Any taxpayer without qualifying children must meet the following requirements:

Principal residence requirement. The taxpayer has a principal residence

in the U.S. for over half the tax year.

Age requirement. The individual or his/her spouse (if married) is at least age 25 but not over age 64 by the end of the tax year.

Nondependent requirement. The taxpayer cannot be claimed as a dependent for the tax year in which the credit is claimed.

Limits on earned income. Phaseout ranges apply.



Eligible taxpayers with qualifying children. Any taxpayer with qualifying children must

meet the following requirements:

Principal abode of child. The taxpayer must maintain a household in the U.S. that is

the principal abode for over half a year of a dependent child under age 19 or a student, dependent disabled child, or married child for whom the taxpayer may claim a dependency exemption. Foster children must occupy the taxpayer’sabode for the entire year.

Head of household or surviving spouse taxpayers. For individuals qualifying as head of household or surviving spouse, a child who is under age 19 or a student need not be a dependent.

Married taxpayers. Married taxpayers must file jointly to receive the credit.

Limits on earned and unearned income. Phaseout ranges apply.




Earned income defined. Earned income includes wages, salaries, tips, net earnings from self-employment, and nontaxable compensation (e.g., military allowance). Excluded from earned income are interest, dividends, welfare benefits, veteran’s benefits, pensions, annuities, unemployment compensation, and scholarships.




Earned Income Credit—Computations

Multiply the taxpayer’s earned income, not to exceed the earned income limit, by the applicable percentage below.

Maximum Earned Income Credit Amounts for 2003

Qualifying Children

Applicable Percentage

(a)

Earned Income Limit

(b)

Maximum EIC

(c) = (a) x (b)

0 7.65% $4,990 $ 382

1 34% $7,490 $2,547

2 or more 40% $10,510 $4,204



Earned Income Credit—Computations


Earned Income Credit Phaseout Amounts for 2003

Qualifying Children

Applicable Phaseout

Percentage

AGI

Beginning Phaseout Amount

Ending Phaseout Amount

0 7.65% $ 6,240 $11,230

1 15.98% $13,720 $29,666

2 or more 21.06% $13,720 $33,692

The maximum earned income credit is subject to the above phaseout amounts. The phaseouts for married filing jointly are $1,000 higher. A phaseout amount is calculated as follows:

Applicable phaseout percentage x (AGI [or earned income if greater] – Beginning phase amount)

No earned income credit is available when AGI or earned income exceeds the ending phaseout amount.


FACTS: In 2003, Gerry, who otherwise qualifies for the earned income credit, receives wages of $15,000 and has no other income. She has one qualifying child.

QUESTION: What is Gerry’s earned income credit?

SOLUTION: Earned income credit is $2,344

$7,490 x 34% = $2,547 Maximum earned income credit

($15,000 – $13,730) x 15.98% 203 Phaseout amount

$2,344 Earned income credit

Earned Income Credit—Example



Obtaining Credit for Excess Withholdings

Excess federal income tax withholdings. Withholdings from employee wages for income tax are treated as refundable credits reported on page 2 of Form 1040.




Excess FICA withholdings: 2 or more employers. Withholdings from wages for FICA tax are also refundable, but only if the aggregate withheld by two or more employers is in excess of the maximum. The refundable amount is reported as a credit on page 2 of Form 1040. (Employers are not entitled to this same credit.)



Excess FICA withholdings: 1 employer.

If the FICA tax withheld by only one employer exceeds the maximum limit, the employee must seek a refund from the employer, not the IRS.




Estimated Tax Payments—Overview Estimated tax requirements. Generally , taxpayers must make quarterlyestimated tax payments if:

(a – c) $1,000; AND(c) is less than the lesser of (d) or (e)

Where:a = Actual tax liability for the current year, including self-employment tax

(i.e., FICA), the alternative minimum tax, and the “nanny” taxb = Actual tax liability for the prior yearc = Amount of taxes withheld by any payor (usually an employer) in the

current year plus any other tax credits expectedd = 90% of (a)e = 100%* of (b) if prior year AGI $150,000 ($75,000 if married filing

separated) * Change 100% to 110% if prior year AGI > $150,000.



Estimated Tax Payments—Overview


Quarterly estimated tax payments. The regular installment method generally results in lower estimated tax payments if income is received fairly evenly throughout the year. Under this method, minimum estimated tax paid each quarter is based on the following formula:

25% x [(The lesser of (d) or (e)) – (c)]Where:a = Actual tax liability for the current year, including self-employment tax

(i.e., FICA), the alternative minimum tax, and the “nanny” taxb = Actual tax liability for the prior yearc = Amount of taxes withheld by any payor (usually an employer) in the

current year plus any other tax credits expectedd = 90% of (a)e = 100%* of (b) if prior year AGI $150,000 ($75,000 if married filing

separated) * Change 100% to 110% if prior year AGI > $150,000.



Quarterly payment due dates. Estimated tax payments are due by April 15, June 15, and September 15 of the current year, and by January 15 of the following year. Note that these quarterly payments are not in 3-month increments, (e.g., April 15 to June 15 is two months, September 15 to January 15 is four months).




Penalties for underpayments. A penalty is imposed for underpayment of estimated tax. The penalty is the amount of the underpayment times the underpayment interest rate prorated for each day of underpayment. The underpayment penalty is applied when an actual quarterly payment is less than the quarterly amount required. No penalty is imposed if the tax liability is less than $1,000.

The underpayment interest rate is the monthly applicable federal rate published by the IRS, plus 3%.



Estimating Taxes—Example


FACTS: Fred’s actual 2002 tax liability is $14,000 and his 2002 AGI is $100,000. In April 2003, Fred estimates that his tax withholdings for 2003 will equal his tax liability and makes no quarterly estimated payments during the year. In March 2004, Fred determines that the actual tax liability for 2003 is $15,000 and his actual withholdings are $12,000.

QUESTIONS: Should Fred have made quarterly estimated tax payments? How much?

SOLUTION: Fred should have made quarterly estimated payments because:$15,000 actual tax liability exceeds $12,000 withholdings by over $1,000; and$12,000 withholdings are less than, the lesser of $13,500 or $14,000, where, $13,500 = 90% x current year tax liability of $15,000, or $14,000 = 100% x prior year tax liability of $14,000.

The minimum amount of Fred’s quarterly estimated payments is $375:

$375 = 25% x [{The lesser of $13,500 or $14,000} - $12,000 withholdings]


Alternative Minimum Tax—History

Effective year

Event

1969 Congress imposed a 10% tax on the sum of 10 tax preference items, reduced by a $30,000 exemption.

1976 Congress increased the tax to 15% and reduced the exemptions.

1979-1982 The minimum tax was computed as the greater of an “add-on” minimum tax and the alternative minimum tax.

1983 The “add-on” minimum tax was repealed and the scope of the alternative minimum tax was expanded to include more tax preference items.

1987 The alternative minimum taxable income concept was introduced.

1991 The alternative minimum tax was increased to 24%.

1993 to Present

Congress increased the alternative minimum tax rate yet again: 26% of net AMTI up to $175,000 ($87,500 if married filing separately); 28% of net AMTI over $175,000 (over $87,500 if married filing separately).



Nonrefundable CreditsNonrefundable credits do not reduce alternative minimum tax liability (AMT) for individuals (except the foreign tax credit). However, they may reduce regular tax to the extent of tentative minimum tax (TMT).

Applying Nonrefundable Credits Example 1 Example 2

(a) TMT $100 $120

(b) Regular tax before nonrefundable credits (e.g., a general business credit (GBC))

120 100

(c) = (a) – (b) AMT $ 0 $ 20

(d) = (b) – (a) Excess regular tax (regular tax before GBC, less TMT) 20 0

(e) GBC available 50 50

(f) = (d) Allowable GBC, limited to excess regular tax 20 0

(g) = (b) – (e) Regular tax after GBC $100 $100

Note: If (e), the $50 credit, had been a foreign tax credit instead of a general business credit, it could have been applied against the $20 AMT in example 2.


Documents

CCH Federal Taxation Basic Principles Chapter 9 Tax Credits, Prepayments, and Special Methods ©2003, CCH INCORPORATED 4025 W. Peterson Ave. Chicago, IL