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CHAPTER 6

CHAPTER 6 . Credits and Special Taxes. 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

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CHAPTER 6

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  1. CHAPTER 6 Credits and Special Taxes

  2. Objective Know the difference between deductions and credits

  3. 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

  4. Tax Credits Illustration of difference between a $1,500 deduction and a $1,500 credit DeductionCredit AGI $ 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

  5. Objective Be able to calculate several common tax credits

  6. 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

  7. 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%

  8. Elderly Credit Example 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

  9. 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. Elderly Credit Example 2

  10. 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

  11. 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

  12. 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

  13. 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

  14. 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

  15. 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)

  16. 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

  17. 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

  18. 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

  19. 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)

  20. 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

  21. 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

  22. 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

  23. 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

  24. 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

  25. 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

  26. 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

  27. Objective Have a general understanding of the Alternative Minimum Tax Calculations

  28. 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

  29. 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

  30. 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

  31. 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)

  32. 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 AMT Example

  33. AMT Example AMT Calculation TI from Form 1040 $ 68,000 Add back positive adjustments: Exemptions 6,000 Real Estate Taxes 10,000 Subtract negative adjustment (none) 0 Add back tax preference items (none) 0 AMTI $ 84,000 AMT Exemption (49,000) $ 35,000 AMT tax rate x 26% Alternative Minimum Tax $ 9,100

  34. Objective Understand the rules for computing tax on the unearned income of minor children

  35. 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

  36. 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”

  37. 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

  38. Objective Know the different rules for married taxpayers residing in community property states

  39. 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)

  40. That’s all!

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