CHAPTER 6
Credits and Special Taxes
©2003 South-Western College Publishing, Cincinnati, Ohio
Objective
Know the difference between
deductions and credits
© 2003 South-Western College Publishing
Transparency 6-2
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
© 2003 South-Western College Publishing
Transparency 6-3
Tax Credits
Illustration of difference between a $1,500 deduction and a $1,500 credit
AGI
Deduction
Deduction
$ 70,000
Credit
$ 70,000
(1,500)
-0-
TI
$ 68,500
$ 70,000
Tax Liability
$ 13,620
$ 14,070
Credit
Tax due
-0$ 13,620
(1,500)
$ 12,570
*This is assuming a single taxpayer in the 30% tax bracket
© 2003 South-Western College Publishing
Transparency 6-4
Objective
Be able to calculate several
common tax credits
© 2003 South-Western College Publishing
Transparency 6-5
Elderly/Disabled Credit
(Schedule R)
 Provides tax relief for those not adequately
covered by Social Security
 Targets taxpayers > 65, or < 65 with total
disability
 This credit rarely shows up - qualifying is
very difficult
© 2003 South-Western College Publishing
Transparency 6-6
Elderly/Disabled Credit Calculations
 For 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%
© 2003 South-Western College Publishing
Transparency 6-7
Elderly Credit Example
Sue is single, 68, and has Dividend income
Schedule E income
Nontaxable SS
Wages
=
=
=
=
$ 150
$4,400
$3,200
$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
© 2003 South-Western College Publishing
Transparency 6-8
Elderly Credit Example 2
Wayne 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.
© 2003 South-Western College Publishing
Transparency 6-9
Child Tax Credit
 Provides 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
© 2003 South-Western College Publishing
Transparency 6-10
Child Tax Credit Example
Taxpayers 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
© 2003 South-Western College Publishing
Transparency 6-11
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
© 2003 South-Western College Publishing
Transparency 6-12
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
© 2003 South-Western College Publishing
Transparency 6-13
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
© 2003 South-Western College Publishing
Transparency 6-14
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)
© 2003 South-Western College Publishing
Transparency 6-15
Dependent Care Credit Examples
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
$18,400
His 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 = $3,600
Lou’s earnings
$3,000
Multiply by % based on new AGI:
$3,000 x .23 = $690 credit
© 2003 South-Western College Publishing
Transparency 6-16
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
© 2003 South-Western College Publishing
Transparency 6-17
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
© 2003 South-Western College Publishing
Transparency 6-18
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)
© 2003 South-Western College Publishing
Transparency 6-19
Education Credits -Example
Dave 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
© 2003 South-Western College Publishing
Transparency 6-20
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
X
U.S. Tax Liability
before the credit
 Thus, may not get full credit
 Can carryback 2 years and forward 5 years
© 2003 South-Western College Publishing
Transparency 6-21
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.
Calculate
Maximum 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
© 2003 South-Western College Publishing
Transparency 6-22
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
© 2003 South-Western College Publishing
Transparency 6-23
Work Credits
 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
© 2003 South-Western College Publishing
Transparency 6-24
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
© 2003 South-Western College Publishing
Transparency 6-25
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
© 2003 South-Western College Publishing
Transparency 6-26
Objective
Have a general understanding
of the Alternative Minimum Tax
Calculations
© 2003 South-Western College Publishing
Transparency 6-27
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
© 2003 South-Western College Publishing
Transparency 6-28
Alternative Minimum Tax
 Calculation of Alternative Minimum Taxable
Income (AMTI)
+/+
-
Taxable Income (from 1040)
Adjustments
Tax Preferences
AMT Exemption
AMTI
AMTI x rate = Alternative Minimum Tax
© 2003 South-Western College Publishing
Transparency 6-29
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
© 2003 South-Western College Publishing
Transparency 6-30
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 nongovernmental 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)
© 2003 South-Western College Publishing
Transparency 6-31
AMT Example
Ralph and Lana (MFJ) report the following on their Form
1040:
Gross income:
Salary
$ 70,000
Dividends/Interest
10,000
Schedule C income
30,000
40,000
AGI
$110,000
Itemized Deductions:
Real Estate taxes
$10,000
Mortgage interest
18,000
Non cash contributions
8,000
( 36,000)
Exemptions ($3,000 X 2)
( 6,000)
Taxable Income
$ 68,000
Regular Tax
$ 11,730
© 2003 South-Western College Publishing
Transparency 6-32
AMT Example
AMT Calculation
TI from Form 1040
Add back positive adjustments:
Exemptions
Real Estate Taxes
Subtract negative adjustment (none)
Add back tax preference items (none)
AMTI
AMT Exemption
AMT tax rate
Alternative Minimum Tax
© 2003 South-Western College Publishing
$ 68,000
6,000
10,000
0
0
$ 84,000
(49,000)
$ 35,000
x 26%
$ 9,100
Transparency 6-33
Objective
Understand the rules for
computing tax on the unearned
income of minor children
© 2003 South-Western College Publishing
Transparency 6-34
Unearned Income of Minor
Children
 Provision 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 rate
NUI = Unearned income - (greater of $750 or Investment
expenses) - $750
© 2003 South-Western College Publishing
Transparency 6-35
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 child
Pay 15% on next $750
The remainder is reported on parent’s 1040 as “other income”
© 2003 South-Western College Publishing
Transparency 6-36
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 $750
as 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
© 2003 South-Western College Publishing
Transparency 6-37
Objective
Know the different rules for
married taxpayers residing in
community property states
© 2003 South-Western College Publishing
Transparency 6-38
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)
© 2003 South-Western College Publishing
Transparency 6-39
That’s all!
© 2003 South-Western College Publishing
Transparency 6-40