Welcome. Learning Objectives

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1 Welcome Welcome to 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition), developed by Sidney Kess and Barbara Weltman. This course brings the tax preparer up-tospeed in preparing 2015 tax returns for the 2016 filing season. This course covers generally applicable tax knowledge for your personal and professional development. Any time spent completing this course is personal to you, is not part of your job duties and, as such will not be compensated. This course reviews how the tax liability is computed, then describes different credits and deductions. After examining the computation of tax, the course discusses the distinction between a tax deduction and a tax credit. To help you further research this topic, links from cited documents (e.g. Code and Regulation sections, IRS releases and publications, cases, etc.) to the full text of such documents are provided within CCH Learning Center courses. You must be a subscriber to CCH Intelliconnect to take advantage of this powerful content integration functionality. Visit CCH Group for more information about CCH Intelliconnect and how to subscribe. Learning Objectives Upon completing this course, you should be able to: Determine whether to use the Tax Table or Tax Computation Worksheet to figure the tax Determine whether Schedule D, a separate worksheet, or Schedule J is necessary to figure the tax Figure each type of personal tax credit Distinguish between refundable and nonrefundable credits Identify business tax credits and understand the limitations under the general business credit CCH Incorporated Terms and Conditions 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 1

2 Tools and Resources Along with helpful comments and links to citations given throughout this course, Tools and Resources are provided to help you: Gain in-depth knowledge of the topic Learn the newest developments on the subject Apply what you ve learned to your practice Subscribers to CCH IntelliConnect may also get news related to this topic sent directly to them, including news headlines and stories, full text of primary source documents cited, and an optional daily or RSS feed. Sign up for customized news feeds from the CCH Tax Tracker. Advance Release Documents - Earned Income Credit Advance Release Documents - Child Tax Credit 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 2

3 Reference Materials IRS Forms and Publications You will need Acrobat Reader to view or print the Portable Document Format (PDF) resources. If you need to install it, download the free plugin from Adobe's website. Forms: Form 1040, U.S. Individual Income Tax Return Form 1040 Instructions Form 1040 Schedule D, Capital Gains and Losses Instructions to Schedule D Form 1040 Schedule EIC, Earned Income Credit Form 1040 Schedule J, Income Averaging for Farmers and Fisherman Form 1098-T, Tuition Statement Form 1116, Foreign Tax Credit Form 2441, Child and Dependent Care Expenses Form 3468, Investment Credit Form 3800, General Business Credit Form 4136, Credit for Federal Tax Paid on Fuels Note Final versions of all 2015 tax forms, schedules, and other publications have not been released. We have used the most current versions available at the time this course was posted. Additional tax legislation, court decisions and IRS pronouncements could affect 2015 returns Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 3

4 Reference Materials IRS Forms and Publications Forms, continued: Form 5405, First-Time Homebuyer Credit and Repayment of the Credit Form 5695, Residential Energy Credit Form 5884, Work Opportunity Credit Form 6765, Credit for Increasing Research Activities Form 8396, Mortgage Interest Credit Form 8582CR, Passive Activity Credit Limitations Form 8586, Low-Income Housing Credit Form 8609, Low-Income Housing Credit Allocation and Certification Form 8826, Disabled Access Credit Form 8839, Qualified Adoption Expenses Form 8844, Empowerment Zone Employment Credit Form 8845, Indian Employment Credit Form 8846, Credit for Employer Social Security and Medicare Taxes Paid on Certain Employee Tips Form 8850, Pre-Screening Notice and Certification Request for the Work Opportunity Credit Form 8863, Education Credits Form 8874, New Markets Credit Form 8880, Credit for Qualified Retirement Savings Contributions Form 8881, Credit for Small Employer Pension Plan Startup Costs Form 8882, Credit for Employer-Provided Child Care Facilities and Services Form 8885, Health Coverage Tax Credit Form 8907 Nonconventional Source Fuel Credit Form 8908, Energy Efficient Home Credit Form 8932, Credit for Employer Differential Wage Payments Form 8936, Qualified Plug-in Electric Drive Motor Vehicle Credit Form 8941, Credit for Small Employer Health Insurance Premiums Form 8962, Premium Tax Credit Publications: IRS Publication 225: Farmer s Tax Guide IRS Publication 334: Tax Guide for Small Business, Chapter Four, General Business Credit IRS Publication 501: Exemptions, Standard Deduction, and Filing Information IRS Publication 503: Child and Dependent Care Expenses IRS Publication 514: Foreign Tax Credit for Individuals IRS Publication 524: Credit for the Elderly or the Disabled IRS Publication 596: Earned Income Credit IRS Publication 970: Tax Benefits for Education IRS Publication 5120: Facts About the Premium Tax Credit 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 4

5 Tax Computation New This Year Tax rates. The tax brackets have been adjusted for inflation as reflected in the 2015 tax rate tables and schedules. Personal exemptions. The personal and dependency exemption amount is $4,000. Personal exemptions phase-out. The phase-out limits for high-income taxpayers have been adjusted for inflation. Introduction After entering income (including income from sales, exchanges, and certain other transactions explained in 1040 Preparation and Planning 5: Acquisition and Disposition of Property) and deductions on the tax return, it is time to make an additional subtraction for personal exemptions, and itemized or standard deductions to arrive at taxable income. This is the amount on which the tax is figured. However, the tax that is figured on taxable income is not the final tax amount. The tax is reduced by tax credits to which a taxpayer is entitled. The tax is increased by additional taxes (e.g., the alternative minimum tax, self-employment tax, the additional Medicare tax on net investment income). The tax is also increased by recapture amounts (e.g., first-time homebuyer credit in some cases) and by tax penalties (e.g., 10% penalty on early distributions from IRAs, shared responsibility payment for lacking minimum essential health coverage). Tax credits are explained in this course. Recapture amounts, tax penalties, and other adjustments to the tax are discussed in other 1040 Preparation and Planning courses. Personal Exemptions Following is how personal exemptions are taken into account in figuring the tax. In 2015, each exemption allowed amounts to a deduction of $4,000. There is no limit on the number of exemptions that can be claimed by a taxpayer. Use the following to figure the deduction based on the applicable number of exemptions: Number of Exemptions Deduction 1 $4, , , Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 5

6 4 16, , , , ,000 The deduction for exemptions, plus itemized deductions or the standard deduction, is subtracted from adjusted gross income to arrive at taxable income. Pitfall Taxpayers who claim a large number of exemptions may fall subject to the alternative minimum tax (AMT). The reason: Personal exemptions are not deductible for AMT purposes. Personal Exemptions > Reduction in the Deduction for Exemptions The deduction for exemptions is phased out for taxpayers with adjusted gross income over a threshold amount applicable to their filing status: Filing status Phase-out begins when AGI exceeds: Exemptions completely phased out when AGI exceeds: Married filing jointly $309,900 $432,400 and surviving spouse Head of household $284,050 $406,550 Single $258,250 $380,750 Married filing separately $154,950 $216,200 For those within the phase-out range, the deduction for exemptions is reduced by 2% for every $2,500 (or fraction thereof) of AGI in excess of the starting phase-out amount. For married persons filing separately, the reduction is 2% for every $1,250 (or fraction thereof) of the starting phase-out amount. Example Mila Stevens is single with AGI in 2015 of $265,000; she has no dependents. Her deduction for the personal exemption is $3,760 ($4,000 reduction of 6% of $4,000). The reduction is $240, which is 6% of the exemption; it is derived by the excess AGI over the starting phaseout amount $6,750 $2,500 = 2.7 rounded to 3 x 2% Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 6

7 Study Questions In 2015, a married couple with three dependent children can deduct how much for their exemptions (assuming the couple s AGI does not exceed the threshold for the phase-out)? $4,000 $8,000 $12,000 $20,000 With respect to personal exemptions, which statement is not correct? The dollar amount for each exemption in 2015 is $4,000. A large number of exemptions may trigger or increase alternative minimum tax. There is no phase-out for personal exemptions. There is no limit on the number of exemptions that can be claimed Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 7

8 Tax Computation Tax Rates The total tax is arrived at by applying the appropriate rates to taxable income (Code Sec. 1). No matter which method of computing tax is used (whether the Tax Table, the Tax Computation Worksheet, the Qualified Dividends and Capital Gain Tax Worksheet, or Schedule J), the total tax is determined by the tax rates. A seven-bracket rate structure applies to taxable income other than capital gains 10%, 15%, 25%, 28%, 33%, 35%, and 39.6%. Taxpayers with long-term capital gains or qualified dividends will pay zero, 15%, or 20% on these income items, even though their ordinary income is subject to the tax rates on ordinary income. This is accomplished by figuring the tax using the Qualified Dividends and Capital Gain Tax Worksheet. Tax Table Generally, all taxpayers with taxable incomes of less than $100,000 must use the Tax Table to figure their tax liability. In using the Tax Table, taxpayers merely find their taxable income line and their appropriate filing status column. Example In 2015, George Byran received a salary of $52,425 plus other income of $9,000. He has business deductions of $400 and itemized deductions of $14,000. He is 66 years of age; his wife, Eva, is 42. Both have normal vision; Eva Byran had no income or deductions. They have one dependent child. Filing a joint return, they will compute their tax as follows: Adjusted gross income $61,025 Less: Itemized deductions $14,000 Less: Personal exemptions (3 $4,000) 12,000 26,000 Taxable income $35,025 First, they find the $35,000 $35,050 income line in the Tax Table. Next, they find the column for Married Filing Jointly and read down the column. The amount shown where the income line and filing status column meet is $4,331. This is their tax Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 8

9 Study Questions Which rate is not a tax rate for 2015? 15% 25% 31% 35% Using the Tax Table found in the instructions to Form 1040, what is the correct tax for a married couple with taxable income of $84,071? $12,606 $15,341 $16,813 $17, Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 9

10 Tax Computation Taxpayers Using the Tax Computation Worksheet Taxpayers must use the Tax Computation Worksheet to figure their tax if their taxable income is $100,000 or more. There are four sections in the worksheet: for single, for married filing jointly, for married filing separately, and for heads of households. In general, the Tax Computation Worksheet calculates the tax by applying the tax rates (25%, 28%, 33%, etc.) to the appropriate amounts of taxable income at the various income tax brackets for the year. Always check the IRS Web site at or other available resources for latest versions of all worksheets, publications, and forms. Example Lou and Jamie Hudson are a married couple filing jointly with four personal exemptions and an adjusted gross income of $200,000 for They will use the Tax Computation Worksheet because their 2015 taxable income is too high to use the Tax Table. Their itemized deductions for the year total $48,200. They would compute their taxable income for 2015 as shown in the table below, followed by the Tax Computation Worksheet and the Hudsons Tax Computation section from Form Adjusted gross income $200,000 Less: Itemized deductions after reduction $48,200 Personal exemptions (4 $4,000) 16,000 64,200 Taxable income $135,800 Tax from the Tax Computation Worksheet is $25, Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 10

11 Study Questions A married couple with taxable income of $125,000 (and no qualifying dividends or capital gains) figures the tax using: Tax Tables Tax Computation Worksheet Tax Tables and Tax Computation Worksheet Qualifying Dividends and Capital Gain Worksheet For 2015, the 15% tax bracket has not been adjusted for inflation. True False 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 11

12 Tax Computation Qualified Dividends and Capital Gain Tax Worksheet to Figure Tax Taxpayers who had a net capital gain from a sale or exchange use Form 1040 Schedule D, Part III, to determine which, if either, of the capital gains tax worksheets to use to calculate the amount of capital gains tax. For taxpayers with sales or exchanges of assets taxed at the 28% rate or with unrecaptured Code Sec gains or both, complete the Schedule D Tax Worksheet in the instructions to Schedule D of Form All other taxpayers, including those with net long-term capital gains and/or qualified dividends, must figure their tax using the Qualified Dividends and Capital Gain Tax Worksheet from instructions to Form Using the Qualified Dividends and Capital Gain Tax Worksheet ensures that net longterm capital gains will be taxed at the applicable rate (0%, 15%, 20%, 25%, or 28%). Follow the line-by-line directions to compute the tax. If a taxpayer has capital gains subject to the 25% or 28% tax rates, then use the Schedule D Tax Worksheet to compute tax liability. Farm and Fishing Income Averaging Taxpayers who earn their income from farming or commercial fishing can elect to figure the tax on this portion of their income by using special averaging over three years. The tax is figured on Form 1040 Schedule J. Under this averaging method, tax for the current year is equal to the sum of the tax figured on taxable income reduced by elected farm/fishing income (business income subject to this election), plus the tax that would have resulted if each of the three prior years were increased by an amount equal to one-third of elected farm/fishing income. The tax rates for the three prior years are listed in the instructions to Schedule J. Farm income includes gain from the sale or disposition of property (other than land) regularly used for a substantial period of time in a farming business. Farming business includes operating a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts, or other crops, or ornamental trees Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 12

13 Planning Pointer Farm income averaging results in a lower tax only when income in the three prior years was significantly lower overall than the current year. However, figure the tax in the usual way to know if income averaging results in any tax savings. Note Income averaging also applies for purposes of alternative minimum tax. Rounding Off Whole-Dollar Amounts Taxpayers have the right to round off to the nearest even dollar all amounts appearing on their income tax returns and accompanying schedules. Amounts of less than 50 cents are eliminated and amounts of 50 cents or more are raised to the next dollar, as illustrated below: Exact Amount: To be Reported as: $18.49 $ Bear in mind that this privilege applies only to amounts required to be reported on a return, not to items that must be taken into account in making the computations necessary to determine such amounts. Example Clint Clancy rents out his unused garage at a monthly rental rate of $ Because his income tax return requires him to report only the total yearly rent received, he must report $ ($25.45 x 12), which he may round off to $305. He cannot compute the reportable rent by rounding off each month s rent to $25.00 and multiplying this amount by 12 to arrive at a total of only $300. Recent Developments Affecting Tax Computation Note For the IRS explanation of tax computation, see: IRS Publication 501: Exemptions, Standard Deduction, and Filing Information IRS Publication 225: Farmer s Tax Guide 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 13

14 Study Questions A single taxpayer with taxable income of $44,000 (which includes qualified dividends of $1,500 and net capital gains of $2,000) figures his tax using: Tax Tables Tax Computation Worksheet Tax Tables and tax Computation Worksheet Qualifying Dividends and Capital Gain Worksheet With respect to income averaging, which statement is correct? It applies to all income received by a farmer or fisherman. It applies to all taxpayers It applies only to farm/fishing income. It does not apply for alternative minimum tax. Bob Eagleton opts to round off numbers on his return. Which figure is not rounded off to $19? $18.49 $18.50 $18.51 $ Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 14

15 Tax Credits New This Year Premium health credit. The household income limitation for the excess advanced credit payments have increased (Rev. Proc , IRB ). Health coverage tax credit. This credit for individuals who qualify for Trade Adjustment Assistance has been reinstated retroactively to 2014 (Trade Preferences Extension Act of 2015). Adoption credit. The adoption credit increased to $13,400. Child tax credit. The refundable child tax credit cannot be taken by anyone claiming an exclusion for foreign earned income or foreign housing (Trade Preference Extension Act of 2015 (P.L )). Retirement saver s credit. The income eligibility limits have been adjusted for inflation (Notice , IRB , 905). Earned income credit. The basic credit, earned income phase-out limits, and unearned income limit have been adjusted for inflation, marriage penalty relief has been provided, and the phaseout ranges for those with three or more qualifying children have been increased (Rev. Proc , IRB ) What Is a Tax Credit? Taxpayers entitled to a tax credit are considered to have paid that amount toward their tax liability. In other words, each dollar of credit reduces the tax liability by one dollar. Note the distinction between a tax deduction and a tax credit. A tax deduction is subtracted from income (gross income or adjusted gross income, as the case may be) when computing the income on which the tax is figured. A tax credit, on the other hand, is generally deducted from the tax after it has been computed. Obviously, a tax credit is much more valuable than a tax deduction; a taxpayer in the 15% tax bracket, for instance, saves approximately 15 cents for each dollar of deductions and one dollar in taxes for each dollar of credit. For the average taxpayer, the most important and most often encountered credits are the child tax credit, the earned income credit, higher education credits, the credit for certain home energy improvements, and a credit for child care expenses. There are also several credits available to individuals who own a business or have certain investments Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 15

16 Most credits can be used only to the extent there is tax liability to offset. However, the earned income credit, the premium tax credit, a portion of the child tax credit and the American opportunity tax credit are called refundable credits because they can be used to generate a tax refund in excess of a taxpayer s tax liability. Credits are claimed on page 2 of Form 1040, in the section of the return Payments, immediately following the tax computation. Planning Pointer Certain credits are lost if a taxpayer is subject to the alternative minimum tax (AMT). Nonrefundable personal credits can be used to offset the AMT. What Is a Tax Credit? > Premium Tax Credit Under the Affordable Care Act, individuals may be eligible for a new tax credit, called the premium tax credit, designed to help them pay for coverage so they can meet the individual mandate. The credit is advanceable (an individual can choose to have it paid directly to the insurer chosen from the exchange); it is a refundable tax credit (it can exceed the individuals taxes for the year). All the following conditions must be met to qualify for the credit: Coverage must be obtained through a government healthcare exchange (federal or state), such as HealthCare.gov. Household income must fall within federal poverty guidelines If an individual is offered coverage from an employer the offered coverage, must not be affordable (i.e., the employee s cost exceeds 9.5% of household income defined below) The taxpayer cannot be eligible for a government program (e.g., Medicare, Medicaid, or CHIP, TRICARE) A married person must file jointly, unless he or she is a victim of domestic abuse and files separately The taxpayer cannot be claimed as a dependent on another taxpayer s return Planning Pointer For 2014, taxpayers were on the honor system for reporting their income and other eligibility requirements if they applied for an advance credit from an exchange. After 2014, the government says that information provided by taxpayers will be verified. The IRS has said that anyone who received an advance premium tax credit but failed to file an income tax return for 2014 will be barred from an advance credit in Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 16

17 What Is a Tax Credit? > Household Income Limits Household income limits. Household income must be between 100% and 400% of the federal poverty guideline for their family size to be eligible for the premium tax credit. The federal poverty guidelines for the prior year determine eligibility for the current year (e.g., 2014 poverty guidelines are used to determine credit eligibility for The following table shows 2014 poverty guidelines for the 2015 premium tax credit: Poverty Amounts in the Contiguous States and D.C.* Household size Household income One individual $11,670 (100%) up to $46,680 (400%) Family of 2 $15,730 (100%) up to $62,920 (400%) Family of 3 $19,790 (100% up to $79,160 Family of 4 $23,850 (100%) up to $95,400 (400%) Family of 5 $27,910 (100%) up to $111,640 (400%) Family of 6 $31,970 (100%) up to $127,880 (400%) Family of 7 $36,030 (100%) up to $144,120 (400%) Family of 8 $40,090 (100%) up to $160,360 (400%) *Different household income amounts apply in Alaska and Hawaii (US Dept. of Health and Human Services(hhs.gov)) Household income for purposes of this credit is modified adjusted gross income (MAGI) of everyone in the household (the taxpayer, spouse, and anyone claimed as a dependent). MAGI is adjusted gross income plus any excluded foreign income, nontaxable Social Security benefits (including Tier 1 Railroad Retirement Benefits), and tax-exempt interest, but not Supplemental Security Income (SSI). Planning Pointer Use 2014 income for determining 2015 health coverage and eligibility for the credit; use 2015 income for the credit in Pitfall Taxpayers who fail to have minimum essential coverage must pay a penalty unless they qualify for exemption. The penalty is explained in 1040 Preparation and Planning 7: Special Tax Computations. Those who claimed the credit on an advanced basis must reconcile their income on Form 8962, Premium Tax Credit. This means they must file an income tax return even if their income is below the filing threshold. Form 8962 is also used to claim the credit if an eligible taxpayer did not do so on an advanced basis Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 17

18 Study Question The value of a tax credit depends on the taxpayer s tax bracket. True False 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 18

19 Tax Credits Health Coverage Tax Credit Eligible individuals who have qualified health insurance may claim a credit of 72.5% of premiums covering themselves and certain family members. Eligible individuals are workers who lost jobs due to foreign trade competition and are eligible to receive a Trade Adjustment Allowance (TAA) or an alternative TAA, as well as retirees age 55 or older who are receiving benefits from the Pension Benefit Guaranty Corporation. The government, not the taxpayer, determines eligibility by sending the taxpayer Form 8887, Health Insurance Credit Eligibility Certificate, and specifying whether the taxpayer is an eligible TAA, alternative TAA, or PBGC pension recipient. The credit applies only to qualified health coverage, which is: COBRA (Consolidated Omnibus Budget Reconciliation Act of 1986) A health insurance program offered to state employees or a comparable program A group health plan that is available through the employment of an eligible individual s spouse The credit can be claimed on an advanced basis (i.e., applied monthly toward premiums). Pitfall The health coverage tax credit cannot be claimed if the taxpayer uses the premium tax credit. It is up to the taxpayer to decide which credit produces the greater tax savings. Planning Pointer Because the health coverage tax credit was reinstated retroactive to January 1, 2014, taxpayers eligible for it but who failed to take the credit on their 2014 returns should consider filing for a refund. The credit is figured on Form 8885, Health Coverage Tax Credit. Credit for Child and Dependent Care Expenses Taxpayers who incur child and dependent care expenses necessary for gainful employment are entitled to a credit on a three-tier basis (Code Sec. 21). First, taxpayers with adjusted gross income of $15,000 or less are entitled to a credit equal to 35% of employment-related expenses, to a maximum of $6,000 for two or more qualifying individuals ($3,000 for one). Then, the credit is reduced by one percentage point for each $2,000 of adjusted gross income, 1040 Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 19

20 or fraction thereof, above $15,000. Finally, for taxpayers with adjusted gross income of over $43,000, the credit is 20%. Only those employment-related expenses that do not exceed an unmarried individual s earned income can be taken into account. For married individuals, a joint return must be filed and both spouses must work (part-time work qualifies), or one must work while the other is a full-time student. Also, qualified employment-related expenses cannot exceed the earned income of the lowerearning spouse, and an incapacitated or student spouse will be considered to have received monthly earned income of $250 for one qualifying individual or $500 for two or more qualifying individuals. Credit for Child and Dependent Care Expenses > Qualifying Individual A qualifying individual is a dependent child under age 13, a dependent of any age if disabled, or a disabled spouse. The taxpayer need not provide over half of the qualifying individual s support, but the person must live with the taxpayer for more than half the year. An individual is not treated as having the same residence as the taxpayer if the relationship between them is in violation of local law. For divorced or separated parents, only the custodial parent can claim the credit. Pitfall No credit can be claimed if a required Social Security number for the dependent is not provided. Credit for Child and Dependent Care Expenses > Qualifying Expenses The following expenses quality for the credit: Expenses for out-of-home, non-institutional care of a disabled spouse or dependent who regularly spends at least eight hours a day in the taxpayer s home are eligible for the credit. Expenses that are taken into account include nursery and other preschool fees and wages paid to a maid for general domestic duties (and not merely wages for services for the direct care of a child or sick or disabled dependent). Transportation costs to a day camp or after-school program not on school premises qualify for the credit (e.g., bus fare paid to the camp, but not the parent s cost of driving the child) Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 20

21 The cost of an employment agency fee to find a housekeeper is a qualified expense. Comment The cost of overnight camp does not qualify for the credit. Credit for Child and Dependent Care Expenses > Relative as Housekeeper Even if the taxpayer s mother or mother-in-law or some other near relative is the person entrusted with household and child care responsibilities, the wages paid to her count as credit expenses provided that the taxpayer does not claim the relative as a dependent for tax purposes and provided also that the necessary Social Security taxes are paid on such wages. Child care services provided by grandparents for care of their grandchildren qualify for the credit even if the relatives services do not constitute employment for Social Security purposes. The maximum credit for one qualifying individual ranges from $1,050 for taxpayers with income below $15,000 to $600 for taxpayers with income in excess of $43,000. Similarly, the maximum credit for two or more qualifying individuals ranges from $2,100 to $1,200. Credit for Child and Dependent Care Expenses > Limit Due to Tax-Free Employer-Povided Dependent Care The amount of expenses eligible for the credit ($3,000 for one child or $6,000 for two or more children) must be reduced by the amount of expenses excluded from income because of coverage under an employer-provided dependent care assistance program. Example Mary Miller incurs $5,000 in child care expenses for her son John. Of this amount, $3,000 is reimbursed by her employer under a dependent care assistance program. The amount of expenses eligible for the credit ($3,000) must be reduced by the reimbursement ($3,000) so that Mary may not claim any credit. If the reimbursement were only $1,000, then $2,000 ($3,000 $1,000) would be eligible for the credit. Taxpayers must report the name, address, and taxpayer identification number of the child care provider on their returns. If they do not, their credit and any exclusion from income for dependent care assistance payments may be disallowed Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 21

22 Pitfall The IRS has noted that the failure to include the care provider s tax identification number (e.g., the individual s Social Security number) is one of the most common errors made on individual income tax returns. The credit is figured on Form 2441, Child and Dependent Care Expenses. Page 2 of the form must also be completed if any tax-free employer-provided dependent care was received Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 22

23 Study Questions Jane Edwards, a single parent with two children, ages 8 and 10, pays a babysitter to watch them after school so she can work. Her AGI is $50,000 and she spends $7,500 on this expense. Her maximum dependent care credit is: $1,200 $1,500 $2,100 $7,500 Betty Johnson, a single parent with a 9-year-old child, spends $5,000 on child care. Of this amount, her employer reimburses $2,000. How much of her expenses is taken into account in figuring the dependent care credit? $1,000 $3,000 $5,000 $6, Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 23

24 Tax Credits Credit for the Elderly or the Disabled This credit, which is figured on Form 1040 Schedule R, is designed to give elderly taxpayers and disabled persons with low incomes who receive little or no tax-exempt Social Security, or similar tax-exempt benefit payments, a tax benefit of approximately the same proportion as that received by Social Security beneficiaries (Code Sec. 22). However, because of the ever-increasing standard deduction and personal exemption amounts, it is highly unusual for anyone to qualify for this credit now. The IRS removed the credit line from the return in 2010, and IRS statistics for 2013 returns showed that the credit was claimed on only 66,000 returns (out of million returns filed ( This credit, while still possible for a few taxpayers, is no longer covered in this course. Child Tax Credit Taxpayers with a qualifying child under age 17 may be entitled to a tax credit of up to $1,000 per child (Code Sec. 24). The credit applies only to a son, daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or descendant of any such individual. An individual legally adopted by the taxpayer or an individual who is lawfully placed with the taxpayer for adoption by the taxpayer is treated as a child of such taxpayer by blood. A foster child who is placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction is treated as the taxpayer s child. The credit is figured on a worksheet in the instructions to Form The full credit can be claimed by those with modified AGI under $110,000 on a joint return or $75,000 for singles. For married persons filing separate returns, the threshold is under $55,000. A refundable credit can be claimed even if the taxpayer owes no tax; the minimum amount of earned income taken into account in figuring the refundable credit is $3,000. For those with income over $110,000 on a joint return ($75,000 for singles; $55,000 for married filing separately), the credit is reduced by $50 for each $1,000 (or fraction thereof) of modified AGI in excess of the threshold. No credit can be claimed for those with modified AGI over $130,000 on a joint return, $95,000 for singles, or $75,000 for married filing separately Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 24

25 Example Jane Morgan, who is single and files as head of household, has modified AGI of $78,500 and one child, age 10. Jane s child tax credit is $800 ($1,000 reduced by $200, which is the result of a $50 reduction for each $1,000 or fraction thereof in excess of the applicable threshold amount). The maximum credit is the dollar amount of the credit times the number of qualifying children. So, for example, a family with three children under age 17 has a maximum credit of $3,000. If a taxpayer has two or more qualifying children, a portion of the credit may be treated as a supplemental child credit amount. This amount is the difference between: $1,000 times the number of qualifying children up to income tax liability (tax liability net of credits other than the earned income credit) over tentative minimum tax liability (without any foreign tax credit), and The total of regular tax liability (net of credits other than the earned income credit) and the employee share of FICA reduced by any earned income credit. Child Tax Credit > Additional Child Tax Credit The credit is refundable to the extent of 15 percent of earned income in excess of $3,000 (up to the credit amount). Example In 2015, Joe Smith and his wife, Nora, have earned income of $28,000. They have one child and are eligible to claim a child tax credit of $1,000 per child. After deducting $12,600 as their standard deduction and $12,000 personal exemptions for Joe, Nora and their child, Joe and Nora have taxable income of $3,400 and a tax liability of $343. The child tax credit (which only reduces the tax liability) reduces their tax liability to zero. They can still claim $657 for the additional child tax credit ($1,000 child tax credit $343 used to reduce tax liability). Remember that this credit is refundable, so even though Joe and Nora owe no tax, they will get a refund of at least $657. For taxpayers with three or more children, the refundable credit may be figured using the former supplemental child tax credit formula, which is the excess of Social Security taxes over the earned income credit, instead of the 15% of earned income if it results in a larger refundable amount. Planning Pointer Individuals claiming an exclusion for foreign earned income or foreign housing cannot also claim the refundable child tax credit. They can opt to forego the exclusion in favor of the credit Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 25

26 The withholding tables that employers use to figure withholding from employees wages reflect the child tax credit. Employees will be able to claim withholding allowances for the credit so that, in effect, they will receive the credit ratably throughout the year in their paychecks. It is important for individuals eligible for the credit to complete a new Form W-4 so their employers can adjust withholding accordingly. The taxpayer must provide the dependent s tax identification number in order to claim the credit. Planning Pointer Individuals planning for marital dissolutions need to pay special attention to provisions for the dependency exemption. This, in turn, will affect which parent can claim the child tax credit Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 26

27 Study Questions The maximum child tax credit for one eligible child is: $1,000 $1,050 $3,000 $75,000 The refundable child tax credit is a percentage based on: Earned income Adjusted gross income Taxable income $3, Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 27

28 Tax Credits American Opportunity Credit and Lifetime Learning Credit There are two tax credits for paying for higher education: American opportunity credit (which replaces the Hope credit for 2009 through 2017) and lifetime learning credit (Code Sec. 25A). The credits are quite different in a number of respects but have some of the same requirements. A taxpayer may be eligible for either credit but can claim only one with respect to expenses of each family member. Therefore, it is possible to claim both credits on the same return (e.g., the American opportunity credit for a dependent who is a college senior and the lifetime learning credit for a dependent who is a graduate student). The credits are figured on Form 8863, Education Credits. American Opportunity Credit and Lifetime Learning Credit > American Opportunity Credit The American opportunity credit is a tax credit of up to $2,500 per year for the first 4 years of higher education (the Hope credit had been limited to the first 2 years of higher education). The credit is 100% of the first $2,000 of qualified expenses and 25% of the next $2,000 of qualified expenses. Thus, for example, a student who incurs $4,000 or more of qualified tuition and fees is eligible (subject to modified AGI limits below) for a maximum American opportunity credit of $2,500. The credit is figured on a per-student basis (it is figured separately for each eligible student in the taxpayer s family). Example Ben Silverman has two children, one a freshman and the other a junior in college, and is paying tuition of $8,000 for each. Ben s credit is $5,000 (2 x [100% of $2, % of $2,000]). The credit is 40% refundable, so it can be received even though it is more than the tax liability. However, if a parent waives the credit to allow a dependent (the student) to claim it, the credit is not refundable Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 28

29 Planning Pointer To qualify for the credit a taxpayer can prepay qualified expenses for a semester starting in the first three months of the following year. Thus, a tuition payment in December 2015 for the spring semester starting February 2016 generates an American opportunity credit for American Opportunity Credit and Lifetime Learning Credit > Lifetime Learning Credit This is a credit of 20% of qualified tuition and fees incurred by a taxpayer, a spouse, or dependents. Only $10,000 of qualified expenses can be taken into account. Thus, the maximum credit is $2,000 ($10,000 x 20%). The credit applies on a per-taxpayer basis (all expenses of a taxpayer s children, for example, are totaled and then the credit is figured). Planning Pointer Families with more than one student in school usually will receive a greater tax benefit from claiming the American opportunity credit than the lifetime learning credit. The lifetime learning credit can be claimed for an unlimited number of years (compared with the American opportunity credit, which is limited to the first four years of higher education). The student must be enrolled in an eligible educational institution taking undergraduate or graduate-level courses to acquire or improve job skills. The student need not be enrolled for any minimum course work (as compared with the American opportunity credit requiring at least half-time study). The credit is available in the year the expenses are paid as long as the education commences or continues during that year or during the first three months of the next year. Any qualified tuition and fees paid with loan proceeds are also eligible for the credit. However, no credit can be claimed for any amounts covered by educational assistance that is excludable from gross income, such as employer-provided educational assistance and tax-free scholarships and fellowships. Also, no credit can be claimed if the taxpayer claims a tuition and fees deduction for the same education expenses, assuming the tuition and fees deduction is extended for Planning Pointer Taxpayers may elect not to claim the credit so that they can use other education tax incentives Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 29

30 American Opportunity Credit and Lifetime Learning Credit > Income Limits for Higher Education Credits Different income limits apply to each credit. For the American opportunity credit, the full credit is phased out ratably for those with modified MAGI between $160,000 and $180,000 on a joint return ($80,000 and $90,000 for singles). For the lifetime learning credit, the full credit is phased out ratably for those with modified AGI between $108,000 and $128,000 on a joint return ($54,000 and $64,000 for singles). Modified AGI includes amounts excluded under the foreign earned income exclusion. The phase-out of the American opportunity credit is figured by using the following formula: Formula for Figuring the Reduction in the American Opportunity Credit Singles: Joint returns: Tax credit amount Tax credit amount x x Modified AGI - $80,000 $10,000 Modified AGI - $160,000 $20,000 Example Assume Betty Hale, a single taxpayer with modified AGI of $87,500, incurs qualified education expenses of $6,000 in 2015 for her daughter's college education. The maximum American opportunity credit of $2,500 is reduced by $1,875 ([$87,500 modified AGI $80,000] $10,000). Thus, Betty's maximum allowable American opportunity credit is $625 ($2,500 $1,875 reduction). American Opportunity Credit and Lifetime Learning Credit > Other Rules Applicable to Both Credits The credit can be claimed for the taxpayer and spouse and for dependent children. Planning Pointer Only the parent claiming the exemption is entitled to a credit with respect to that child. Individuals planning for marital dissolution should plan carefully for which parent is entitled to claim a child as a dependent because this will affect eligibility to claim a higher education credit Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 30

31 Planning Pointer The student may claim an education credit if the parent waives the dependency exemption of the child. This may be advisable where the student has sufficient tax liability to be offset by the credit and/or the parent s AGI causes a phase-out of the exemptions. However, no portion of the American opportunity credit is refundable in this case. The credit is recaptured if the taxpayer or child receives a refund of tuition and related expenses. The American opportunity credit cannot be claimed for expenses of a student convicted of a federal or state felony drug offense (there is no similar restriction on the lifetime learning credit). "Higher education" for purposes of the American opportunity credit means enrollment in a postsecondary degree or certificate program at an eligible institution on at least a half-time basis. There is no such requirement for the lifetime learning credit. Qualified expenses include tuition and certain fees required for enrollment or attendance at an eligible educational institution. Charges for student activities, athletics, insurance, transportation, computers and computer technology (unless required by the institution as a condition for enrollment), or other personal expenses are not qualified expenses. See Publication 970, Tax Benefits for Education. However, the expenses of education involving sports, games, or hobbies can be treated as qualified expenses if they are part of the student s degree program. Qualified expenses include only those paid by the taxpayer or student out-of-pocket. Expenses covered by employerprovided educational assistance cannot used to claim a credit. Similarly, qualified expenses are reduced by scholarship and fellowship grants excludable from gross income. Also, if the taxpayer claims a deduction for education expenses because the courses maintain or improve skills or are required by the employer or the law to keep one s current salary or position, no credit can be claimed for the same expenses. Planning Pointer Using savings, gifts, or loan proceeds to pay for higher education costs does not affect eligibility for claiming a higher education credit. Note A credit is not allowed unless the taxpayer receives Form 1098-T, Tuition Statement (Trade Preferences Extension Act of 2015 (P.L )) Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 31

32 Study Question In 2015, Sue Sheldon, a single taxpayer with modified AGI of $59,000, pays college tuition of $10,000 for her son (there are no other students in the family). Her maximum lifetime learning credit is: $1,000 $2,000 $2,500 $4, Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 32

33 Tax Credits Adoption Credit Taxpayers who adopt a child in 2015 may claim a nonrefundable tax credit of up to $13,400 of eligible adoption expenses (Code Sec. 36C). The credit is figured on Form 8839, Qualified Adoption Expenses. Those adopting a special needs child can claim the credit without regard to actual expenses paid. The credit phases out for those with modified adjusted gross income over $201,010 in 2015, and is completely phased out when modified AGI exceeds $241,010. Modified adjusted gross income is AGI before certain foreign income exclusions; the same limit applies to married couples and single filers. The reduction in the credit is figured by applying a percentage figured as follows: Applicable reduction percentage x Modified AGI - $201,010 $40,000 ($241,010 - $201,010) Planning Pointer A taxpayer must have a tax identification number in order to qualify for the credit. Example Tom Peterson has modified adjusted gross income of $211,010, and he paid $8,000 in qualified adoption expenses in 2015 for a child who is not a special-needs child, the same year that the adoption became final. The reduction percentage is 25% ($211,010 $201,010 = $10,000; $10,000 $40,000 = 25%). The taxpayer s maximum credit is $6,000 ($8,000 x 25% = $2,000; $8,000 $2,000 = $6,000). Adoption Credit > Qualified Expenses The credit applies to adoption fees, court costs, attorney s fees, traveling expenses, and other expenses directly related to a legal adoption. The costs of a surrogate parenting arrangement are not qualified expenses. The costs of adopting a spouse s child are not eligible expenses for the credit. Pitfall No credit can be claimed for expenses for which the taxpayer is eligible for the adoption assistance exclusion. Also, no credit can be taken for any amounts reimbursed by an employer. Complete page 2 of Form 8839 to figure the amount of unreimbursed expenses that are eligible for the credit. However, if the adoption expenses exceed $13,400, the taxpayer may qualify for both the exclusion and the credit Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 33

34 Planning Pointer The credit may also be claimed if the adoption falls through in Adoption Credit > Timing of the Credit When adopting a child who is a U.S. citizen or resident, no credit may be claimed in the year the expenses are incurred if the adoption is not final by year-end. Instead claim the credit in the following year, even if the adoption is still not finalized. If expenses are paid in a year following the year in which the adoption has been finalized, the credit may be claimed in that subsequent year. If the child is not a U.S. citizen or resident at the time proceedings start, then a different rule applies. No credit may be claimed until the year the adoption becomes final. Example Carl and Norma Morris, a married couple adopting a child who is a U.S. citizen, incur $3,000 of adoption expenses in 2015, another $1,000 in 2016, and yet another $1,000 in 2017 the year in which the adoption becomes final. Applying the timing rule, no credit may be claimed in 2015 because the adoption did not become final that year. A credit can be claimed in And another credit may be claimed in 2017, the year in which the adoption became final. If the child were a foreign citizen, no credit could be claimed until 2017 when the adoption becomes final. Adoption Credit > Substantiation for the Credit In order to claim an adoption credit, the taxpayer must have certain documents: For U.S. adoptions, attach a copy of the adoption order or decree. For adoptions finalized abroad, include the child s Hague Adoption Certificate, an IH-3 visa, or a foreign adoption decree translated into English. If the child s country of origin is not a party to the Hague Convention, then attach a copy of the translated decree or an IR-2 or IR-3 visa. For a special needs child, also attach the state or county determination certificate to claim the full $13,400, regardless of the adoption costs you paid. The documents do not have to be attached to the return (as required in some prior years); retain them with a copy of the tax return Preparation and Planning 4: Tax Computations and Credits (2016 Edition) 34