Chapter I14
Special Tax Computation Methods, Tax Credits
and Payment of Tax
Discussion Questions
I14-1 Most taxpayers are not subject to the AMT because they do not have substantial tax preferences and AMT adjustments, and because there is a liberal exemption amount to reduce the tax base on which the AMT is calculated. p. I14-2.
I14-2 The Alternative Minimum Tax does not apply if an individual's tentative minimum tax under the AMT rules is less than his regular tax liability. It applies only if the tentative minimum tax exceeds the regular tax liability. p. I14-2.
I14-3 b. only. Only the excess depreciation for real property placed in service before 1987 is a tax preference item. For tax years prior to 1987, net long-term capital gains were a tax preference item (i.e., the 60% long-term capital gain deduction) and for taxable years prior to 1993 the appreciated element related to charitable contributions of capital gain real property was a tax preference item. p. I14-4.
I14-4 a, b, c only. Itemized deductions that are not allowed in computing AMTI, excess depreciation on real property placed in service after 1986, and excess MACRS depreciation for personal property placed in service after 1986, are all AMT adjustments. Tax-exempt interest is not an AMT adjustment but may be a tax preference item if the bonds are private activity bonds. pp. I14-4 through I14-6.
I14-5 a and b only. Charitable contributions and mortgage interest on a personal residence are deductible when computing AMT. Mortgage interest is subject to the restrictions pertaining to qualified housing interest. Other interest is deductible up to the amount of qualified net investment income and since the individual has no investment income, the other interest (investment interest) is not deductible. Medical expenses are deductible only for amounts in excess of 10% of AGI and state and local taxes are not deductible for purposes of AMT. pp. I14-4 and I14-5.
I14-6 Most people are not subject to the self-employment tax because they are classified as employees for tax purposes and make FICA employee contributions instead. p. I14-7.
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I14-7 Tony will have to make social security tax payments in the form of self-employment taxes if he continues to operate his consulting business as a sole proprietor. If Tony continues to be employed, he will not be subject to the non Medicare (OASDI) portion of the self-employment tax on the first $68,400 of earnings. However, any income (i.e., salary or consulting) above this amount will be subject to the hospital insurance (HI) premium portion of the FICA tax (1.45% for employment related income and 2.9% for his self-employment earnings). If he retires, Tony's consulting income will all be subject to the 15.3% self-employment rate on the first $68,400 and 2.9% on income in excess of $68,400 although Tony will then receive a for AGI deduction for one half of self-employment taxes paid. pp. I14-7 and I14-8.
I14-8 If the engagement is set up as a consulting arrangement rather than an employment contract, then the consulting firm will be able to avoid making matching FICA contributions for Theresa. In addition, the consulting firm will not be required to withhold the employee's share of FICA tax either. Theresa will be subject to the self-employment tax. However, if her income as an employee (e.g., college professor) is in excess of the ceiling amount of $68,400 for the OASDI portion of self-employment income, she will not be subject to the 12.4% portion of the tax. She will however, be subject to the 2.9% HI portion on her self-employment income. p. I14-7.
I14-9 a. The taxable base for Ted is $20,000 (which is the lesser of (1) $20,000 self-employment income or (2) $38,400 ($68,400 ceiling - $30,000 FICA wages). Ted's net earnings from self-employment are $18,470 ($20,000 x 0.9235). The self-employment tax for Ted is $2,826 ($18,470 x 0.1530).
The taxable base for Tina is $10,000 (which is the lesser of (1) $10,000 self-employment income or (2) the $68,400 ceiling amount). Tina's net earnings from self-employment is $9,235 ($10,000 x .9235). The self-employment tax for Tina is $1,413 (0.153 x $9,235). Combined self-employment tax on the joint return is $4,239 ($2,826 + $1,413).
b. Ted and Tina are entitled to a business deduction on their 1998 income tax return equal to one-half of the self-employment taxes paid. If they file a joint return the deduction is $2,119 (0.50 x $4,239). pp. I14-7 and I14-8.
I14-10 a. Foreign tax credits are provided to mitigate the effect of double taxation on foreign source income.
b. The research credit is given to encourage research and development activities to enhance our technological base.
c. Business energy credits were designed to encourage energy conservation measures and the use of fuel other than petroleum.
d. The work opportunity credit encourages employers to hire unemployed individuals from economically disadvantaged groups.
e. The child and dependent care credit was enacted to provide equitable relief for parents and other individuals who are employed and who must incur expenses for household and dependent care services.
f. The earned income credit provides special tax breaks for certain low-income individuals who have earned income and dependent children or other incapacitated individuals living in the household. The credit is designed to encourage low-income individuals to become gainfully employed.
g. The purpose of the HOPE scholarship credit is to help low and middle income taxpayers pay for the cost of postsecondary education.
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h. The disabled access credit is to encourage small businesses to make their existing business facilities accessible to disabled individuals.
i. The empowerment zone employment credit is intended to reduce the level of unemployment in distressed urban and rural areas.
j. The adoption credit is designed to assist taxpayers with the financial burden of adopting children.
p. I14-10.
I14-11 For a taxpayer in a 15% tax bracket a $200 deduction is worth $30 and is therefore worth less than a $40 credit. For a taxpayer in a 28% bracket the deduction is worth $56 which is more than a $40 credit. p. I14-9.
I14-12 The general business credit includes the rehabilitation expenditures credit, work opportunity credit, research credit, business energy credits, the empowerment zone credit, work-to-welfare credit and the disabled access credit. The investment tax credit consists of the rehabilitation credit, business energy credit and the reforestation credit. pp. I14-17 through I14-21.
I14-13 a. The general business credit may not exceed the "net income tax" minus the greater of (1) the tentative minimum tax or (2) 25% of the "net regular tax liability" in excess of $25,000.
b. The general business credit is a nonrefundable credit and has a lower priority than personal tax credits. This means that a person must use personal tax credits (as well as the foreign tax credit, orphan drugs testing credit, and nonconventional source fuel credit) to offset their tax liability before the general business credit is used. Since the credit is nonrefundable, if the tax liability has already been eliminated by credits with a higher priority than the general business credit, the taxpayer will only be able to carryback or carryforward the unused general business credit.
c. For tax years beginning after December 31, 1997, the general business tax credit may be carried back 1 year and any remaining credit may be carried forward 20 years. Credits arising from prior years (commencing with the earliest carryover years) are first carried back or forward before credits arising from the current year may be used. p. I14-17.
I14-14 a. The foreign tax credit is equal to the income taxes paid or accrued to a foreign country but limited to the taxpayer's U.S. tax liability times the ratio of foreign source taxable income to worldwide taxable income. This limitation applies when the effective foreign tax rate exceeds the effective U.S. tax rate. In this case the foreign tax rate is lower than the U.S. rate and the foreign tax credit would be $14,000 ($70,000 x 0.20).
b. In this case Wayne would be better off choosing the earned income exclusion since $70,000 of his income each year could be excluded from U.S. taxation resulting in an actual reduction of $21,000 ($70,000 x 0.30) in his U.S. tax liability. pp. I14-16 and I14-17.
I14-15 The work opportunity credit is 40% of up to $6,000 of qualified first-year wages for each qualified employee hired. In this case, the work opportunity credit for King Corporation is $9,600 (0.40 x $6,000 x 4). p. I14-20.
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I14-16 Queen Corporation is eligible for the disabled access credit because it is considered as an eligible small business. Even though the company had $1 million or more of gross receipts in the preceding year it meets the test because it had 30 or less employees. The credit is $5,000 (0.50 x $10,000). The $10,250 ceiling amount does not apply because the cost of the eligible expenditures was only $10,000. The depreciable basis of the property is reduced by the $5,000 allowable credit. p. I14-18.
I14-17 a. The credit for rehabilitation expenditures applies to expenditures for the rehabilitation of older industrial and commercial buildings and certified historic structures. Expenditures may not be for residential real estate unless the structure is a certified historic structure.
b. There is an applicable tax credit rate of 10% for structures placed in service before 1936 and 20% for certified historic structures.
c. Depreciation for expenditures qualifying for this credit must be computed using the straight line depreciation method.
d. For the purpose of depreciation, the basis of the property must be reduced by the full amount of the credit taken.
e. The rehabilitation credit must be recaptured in the event of an early disposition of the property at a rate of 20% per year. Therefore, 20% of the credit is earned per year. pp. I14-18 and I14-19.
I14-18 Solar, and geothermal property which conserves energy qualifies for the business energy credit. p. I14-19.
I14-19 The underlying reason for personal tax credits is to aid social welfare rather than to address economic issues. p. I14-9.
I14-20 A refundable tax credit is a type of negative income tax. If the credit exceeds the tax liability the government pays the taxpayer the remaining excess credit. A nonrefundable tax credit may only be used to offset the tax liability, therefore, if the credit exceeds the tax liability the taxpayer receives no payment and at best can only carryback or carryforward the excess credit. The earned income credit and withholding on wages are refundable tax credits. Child and dependent care credits, tax credits for the elderly and the general business credit are nonrefundable credits. pp. I14-9 through I14-16.
I14-21 If an individual is unemployed and has no earned income, it is not possible to receive a child and dependent care credit because the intention of the credit is to help a person who is employed to pay for dependents in order to enable an individual to work. One exception to this rule is a spouse who is either a full-time student or is incapacitated. Such individuals are deemed to have earned income of $200 per month. pp. I14-9 through I14-12.
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I14-22 There are several significant differences between the HOPE Scholarship Credit and the Lifetime Learning Credit. First, the HOPE credit only applies during a students’ first two years of postsecondary education whereas the Lifetime Learning credit applies to undergraduate, graduate, and professional education. Second, the HOPE credit applies per student (maximum $1,500 per student) whereas the Lifetime Learning credit is based on the amount of dollars spent on qualified tuition and related expenses by the taxpayer. Finally, the HOPE credit applies to only two years whereas the Lifetime Learning credit has no limit on the number of years the credit is allowed.
The principal types of taxpayers most likely to qualify for both credits are low and middle income taxpayers.
pp. I14-14 and I14-15.
I14-23 The maximum child and dependent care credit for an individual who has $4,800 in qualifying child care expenses is $1,440 (0.30 x $4,800). p. I14-12.
I14-24 Vivian's child and dependent care credit is initially limited to the $4,800 ceiling amount which is then reduced by the $3,000 employer reimbursement. The maximum allowable credit is $540 (0.30 x $1,800). pp. I14-11 and I14-12.
I14-25 a. The adoption credit allowed is the amount of qualified adoption expenses incurred in years after 1996 to a maximum of $5,000 ($6,000 for special needs children). The credit is allowable in the year following the year the qualified adoption expenses were paid unless the expenses are incurred in the year the adoption becomes final. This rule is intended to prevent the taking of a credit for adoption expenses where the adoption is not finalized. Finally, there is a phaseout of the credit depending on the taxpayer's AGI. For taxpayers with AGI between $75,000 and $115,000, the credit is ratably phased out and is fully phased out when the taxpayer's AGI reaches $115,000.
b. As with other phase-outs in the tax law, Congress does not intend this credit for higher-income taxpayers.
pp. I14-13 and I14-14.
I14-26 Alice is eligible for the earned income credit since she has qualifying children, and has earned income which does not exceed the phase-out limitation amounts. The credit amount is $3,756 (0.40 x $9,390). There is no scale-down on the credit because Alice's AGI (or earned income if greater) is less than $12,260. If Alice expected to be eligible for the credit, she could obtain advance payment of the credit by filing a Form W-5 with her employer. Alice's employer would increase her pay by the amount of the credit. pp. I14-21 and I14-22.