RATES, CREDITS AGAINST THE TAX, AND SPECIAL ISSUES Recommended CPE Credit: 6 HRS [B] PREPARED BY. CPElite T.M. In a Class By Yourself T.M.

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1 RATES, CREDITS AGAINST THE TAX, AND SPECIAL ISSUES Recommended CPE Credit: 6 HRS [B] PREPARED BY CPElite T.M. In a Class By Yourself T.M. (800) 9500-CPE JUNE, 2012 P.O. BOX 1059, CLEMSON, SC & P.O. BOX 721, WHITE ROCK, SC

2 6/12 QUIZ INSTRUCTIONS RATES, CREDITS AGAINST THE TAX, AND SPECIAL ISSUES There are 7 true-false quiz questions and 23 multiple-choice questions at the end of the course. Choose the best answer based on the limited facts of each question, and record your answer on the enclosed answer sheets. An extra answer sheet below is enclosed for your personal records. The answer sheet to be turned in is on the next page. If you would like to complete the test on-line, go to and click On-Line Testing. You must score 70% to receive continuing professional education credit for this course. You may take the quiz two additional times without incurring additional expense. T.M If your zip code is below 56000, please return your completed answer sheet to CPElite, P. O. Box 721, White Rock, SC If your zip code is above 55999, please return your completed T.M answer sheet to CPElite, P.O. Box 1059, Clemson, SC After you successfully complete the quiz, your quiz results, a complete set of solutions, and a certificate of completion will be mailed to you within 10 working days of our receipt of your answer sheet. The completion date on your answer sheet will be the date designated on your certificate. The latest recommended completion date is within one year of purchase. ANSWER SHEET FOR YOUR RECORDS RATES, CREDITS AGAINST THE TAX, AND SPECIAL ISSUES 6 HOURS OF CPE (Based on 50 Minutes of Average Completion Time Per Hour) Delivery Method Self Study (Latest Recommended Completion Date: Within one year of purchase) Please record your answers below and retain this copy for your records We appreciate your business and hope that you were satisfied with the course. COMPLETION DATE ii

3 6/12 ANSWER SHEET TO BE SUBMITTED RATES, CREDITS AGAINST THE TAX, AND SPECIAL ISSUES 6 HOURS OF CPE (Based on 50 Minutes of Average Completion Time Per Hour) Delivery Method Self Study (Latest Recommended Completion Date: Within one year of purchase) If you would like to complete the test on-line, go to and click On-Line Testing. Otherwise, please record your answers below and mail your solutions to: ZIP CODE BELOW ZIP CODE ABOVE T.M. T.M. CPElite CPElite P.O. Box 721 P. O. Box 1059 White Rock, SC Clemson, SC We appreciate your business and hope that you were satisfied with the course. Please express below your comments on course quality, other topics you would like, or our other products and services NAME ADDRESS [PLEASE PRINT] ADDRESS (Note: We do not share or sell addresses) PHONE NUMBER SIGNATURE COMPLETION DATE PURPOSE OF CPE PTIN (if applicable) (Indicate whether credit is for enrolled agent, RTRP, CPA, or other purpose. For CPA's and other licensed accountants, please indicate state licensed. For CFPs, please provide either the last four digits of your social security number or your certificant/cfp Board ID number). COURSE EVALUATION (Answer Yes, No, or N/A) 1. The stated learning objective was met. 2. Handout or advance preparation materials were satisfactory. 3. The materials were accurate. 4. The materials were relevant and contributed to the achievement of the learning objective. 5. If applicable, prerequisite requirements were appropriate. 6. The time allotted to the learning activity was appropriate. 7. Additional Comments iii

4 RATES, CREDITS AGAINST THE TAX, AND SPECIAL ISSUES Recommended CPE Credit: 6 HRS [B] TABLE OF CONTENTS A. FILING STATUS 1 B. PERSONAL AND DEPENDENCY EXEMPTIONS 3 C. RETURNS OF MINORS C.1 General Filing Considerations 6 C.2 Investment Income of Minors 7 D. TAX RATES D.1 Ordinary Income 10 D.2 Capital Gain Income 11 D.3 Dividend Income 13 E. CHILD TAX CREDIT E.1 General Rules 15 E.2 Phaseout of Child Tax Credit 17 F. DEPENDENT CARE CREDIT F.1 General Rules 18 F.2 Phaseout of Dependent Care Credit 20 G. EARNED INCOME TAX CREDIT G.1 General Rules 22 G.2 Earned Income Tax Credit Compliance Issues 26 H. EDUCATION CREDITS H.1 Hope Education Tax Credit H.2 Lifetime Learning Credit 31 H.3 Non-Regulatory Rules Relating to the Education Tax Credits 32 H.4 Regulatory Rules Relating to the Hope and Lifetime Learning Credits 34 H.5 Credit Phaseout Planning Strategies 36 I. FIRST-TIME HOMEBUYER CREDIT I.1 Establishment of the Credit 37 I.2 Changes to the Credit 38 J. ESTIMATED TAX PAYMENTS 40 K. EDUCATIONAL SAVINGS BOND EXCLUSION 46 L. CLAIM OF RIGHT DOCTRINE 44 M. ALTERNATIVE MINIMUM TAX M.1 Introduction and Alternative Minimum Tax Formula 48 M.2 AMT Adjustments 49 M.3 AMT Preferences 51 M.4 AMT Exemption Amounts 51 M.5 AMT Tax Rates and Credit 52 iv

5 TABLE OF CONTENTS CONTINUED N. PROVISIONS THAT AFFECT HIGHER INCOME TAXPAYERS N.1 Taxability of Social Security Benefits 53 N.2 Limitation on Itemized Deductions 55 N.3 Floor Under Deduction for Medical Expenses 56 N.4 Floor Under Miscellaneous Itemized Deductions 59 N.5 Floor Under Personal Casualty Loss Deduction 61 N.6 Phaseout of Exemption Amount 62 N.7 Phaseout of Eligibility for Deductible (Traditional) IRA 62 N.8 Phaseout of Eligibility for Roth IRA 63 N.9 Phaseout of Eligibility for Contribution to Coverdell Education Savings Account 64 N.10 Other Provisions Affected by Relatively Higher Amounts of Gross Income 65 O. CONCLUDING REMARKS 66 QUIZ QUESTIONS 67 ENDNOTES 72 ONGOING DEVELOPMENTS T.M. CPElite CONTINUES TO MONITOR LEGISLATIVE, ADMINISTRATIVE, AND JUDICIAL DEVELOPMENTS AS THEY OCCUR, AND OUR COURSES ARE UPDATED TO REFLECT TAX LAW CHANGES. ALL RIGHTS RESERVED. THE REPRODUCTION OR TRANSLATION OF THESE MATERIALS IS PROHIBITED WITHOUT THE WRITTEN PERMISSION OF CPElite. T.M. v

6 RATES, CREDITS AGAINST THE TAX, AND SPECIAL ISSUES Recommended CPE Credit: 6 HRS [B] This course contains a discussion of the tax rate structure, selected credits, estimated payments, and selected special issues (including filing status, exemptions, and provisions that affect higher-income taxpayers). This course reflects legislative changes made through the Middle Class Tax Relief and Job Creation Act of 2012, signed by President Obama on February 22, The coverage in this course attempts to focus on recent changes, newly phased-in items, or easily overlooked items with tax planning implications. Tax planning strategies are emphasized. The level of knowledge expected to be imparted by this course is basic. Our courses comply with the enhanced standards required of providers of continuing professional education (the Statement of Standards for Continuing Professional Education (CPE) Programs, issued jointly by the AICPA and NASBA). Specifically, the pass rate percentage for our courses is 70%, our courses contain the required minimum number of quiz questions per CPE hour (5), and our courses contain the required minimum number of review questions per CPE hour (5). We are an IRS-Approved Continuing Education Provider. A. FILING STATUS There are five individual filing statuses for the federal income tax return: (1) married filing jointly; (2) qualifying widow/widower (surviving spouse); (3) married filing separately; (4) head of household; and, (5) single. With respect to married filing jointly status, a joint return can be filed by a man and a woman. They must meet certain tests. They must be legally married on the last day of the tax year to file a joint return. The laws in the state of residence apply in determining if a couple is married. If a couple is in the process of divorce, they are considered to be married until the date that the divorce becomes final. Neither taxpayer may be a 2 nonresident alien, that is both must be a U.S. citizen or resident. Except in the case of death, both taxpayers must have the same tax year. With respect to qualifying widow/widower (surviving spouse) status, a widow or widower can file a joint return for the year in which his or her spouse dies, provided the widow or widower does not remarry. Further, for two years after the death, the widow or widower can file as a surviving spouse. However, to file as a surviving spouse, several conditions must be met: (1) the survivor may not have remarried by the end of the 1

7 tax year in which he or she claims surviving spouse status; (2) the survivor must be a U.S. citizen or resident; (3) the survivor must have qualified to file a joint return in the year in which the spouse died; and, (4) the survivor must have at least one dependent child who lived at home during the entire year, and the survivor must have paid over one-half of the expenses of the home. 3 With respect to married filing separately status, while generally it is better for married taxpayers to file jointly, married taxpayers may elect to file separate returns. Separate filers have no requirement to maintain a household, to have a dependent, or to be a U.S. citizen. Separate filers must use a tax rate schedule in which the rates increase more rapidly than the rates for any other individual tax rate schedule. Some items for married taxpayers who are considering filing separately to take into account are: (1) if one of the spouses has materially more than one-half of the couple s combined income, filing separately increases the couple s total income tax; (2) separate returns may result in more total deductions for the married couple for example, the 7.5% adjusted gross income (AGI) floor under medical expenses and the 10% AGI floor under nonbusiness casualty losses may not be as penalizing on separate returns; and, (3) certain provisions penalize married taxpayers who file jointly, for example, the limited $25,000 rental real estate loss provision in the passive activity loss rules is not available for married taxpayers who file separately, unless the couple live apart the entire taxable year. With respect to head of household status, the taxpayer must be unmarried or be an abandoned spouse. The taxpayer must maintain a household in which a qualified individual lives. There are three types of qualified individuals: (1) unmarried children who live with the taxpayer more than one-half of the tax year (the child must be a qualifying child defined in Section B below); (2) parents who qualify as a dependent parents do not have to live with the taxpayer; and, (3) married children and other relatives they must live with the taxpayer and qualify as a dependent. 4 Regarding the maintenance of a household, the taxpayer must pay over one-half of the costs of maintaining the household. Includible expenses are mortgage interest, property taxes, insurance, rent, utility costs, and upkeep and repairs. Non-includible expenses are clothing, medical treatment, education, and transportation. An abandoned spouse (taxpayer) may file as head of household if: (1) the taxpayer did not live with the spouse during the last one-half of the tax year; (2) a dependent child lives with the taxpayer more than onehalf of the tax year; (3) the taxpayer pays more than 50% of the costs to maintain the home; and, (4) the taxpayer is a U.S. citizen or resident. 5 2

8 With respect to single filing status, the taxpayer must be single on the last day of the tax year. Single filing status is used by a taxpayer who does not qualify as a surviving spouse or for head of household status. Substance over form governs for divorce/remarry schemes (this doctrine thwarts attempts by married taxpayers to avoid the "marriage penalty"). **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 1. With respect to filing status, which one of the following statements is false? a. For married filing jointly, federal laws apply to determine if the couple is married. b. For married taxpayers filing separately, the tax rate schedule increases most rapidly of all individual tax rate schedules. c. For a taxpayer to file single, the taxpayer must be single on the last day of the tax year. Solutions 1. A is the correct response. For married taxpayers filing jointly, state law determines if the couple is married. B is an incorrect response. Separate filers use a tax rate schedule in which the rates increase more rapidly than the rates for any other individual tax rate schedule. C is an incorrect response. A taxpayer who is not single on the last day of the tax year is not permitted to use single filing status. B. PERSONAL AND DEPENDENCY EXEMPTIONS 6 7 The exemption amount for 2011 was $3,700. For 2012, it is $3,800. For 2009, the personal exemption deductions were phased out in connection with AGI. There were a threshold amount, a phaseout range, and a phaseout rate for each filing status. The threshold amounts were indexed for inflation. These items with respect to AGI for 2009 are in the following table. Filing Status Threshold Amount Phaseout Range Phaseout Rate Joint $250,200 $122,500 2% per $2,500 Separate $125,100 $ 61,250 2% per $1,250 Hd Hsehld $108,500 $122,500 2% per $2,500 Single $166,800 $122,500 2% per $2,500 The exemption amount for each exemption was phased out, using the phaseout rate, for each $2,500 increment (or fraction thereof) -- $1,250 for taxpayers filing separate returns -- of the taxpayer's AGI over the threshold amount. 8 3

9 Example 1 Joe and Mary Simpson are married and file a joint return. They have four exemptions, one for each of them, and one for each of their two children. They have AGI of $260,500, and claim the standard deduction of $11,400 for Without regard to the phaseout of personal exemptions (discussed below), the Simpsons would have $14,600 for their exemptions [4 x $3,650]. Their $260,500 of AGI exceeds the threshold amount by $10,300 [$260,500 - $250,200]. It is still within the $122,500 phaseout range. Their personal exemptions are phased out by 10% [($10,300 / $2,500) = 4.12 rounded up to 5 x 2% = 10%]. Therefore, rather than having personal exemptions of $14,600, the Simpsons have personal exemptions of $13,140 [$14,600 - (10% x $14,600), or alternatively 90% of $14,600] tax legislation provides for a repeal of the phaseout of the personal and dependency exemptions. For 2009, the amount of the exemption phaseout is cut by two-thirds. For 2010, there is no phaseout of the exemption amount. For 2011, there was scheduled to be a return to full phaseout of the exemption amount, but late 2010 legislation provides for no phaseout of the exemption amount through Example 2 Refer back to Example 1. The initial calculations resulted in a $1,460 [10% x $14,600] cutback in the exemption amount for the Simpsons in However, the actual cutback in 2009 would be $973 [$1,460 x 2/3]. For , there is no phaseout of the exemption amount for the Simpsons; the Simpsons would be entitled to their full $14,800 in 2011 and $15,200 in Prior to 2010, personal exemption amounts are phased out to the maximum extent, subject to the cutback, once the taxpayer's AGI reaches certain amounts. The AGI amounts for 2009 are: $372,700 for joint filers, $186,350 for married taxpayers filing separately, $331,000 for those filing head of household, and $289,300 for single filers. For 2009, the exemption amount for taxpayers with AGI in excess of the maximum phaseout amount is $2, For purposes of the dependency exemption, there are two classes of dependents: (1) qualifying children, 13 and (2) qualifying relatives tax legislation provides a uniform definition of a qualifying child and a qualifying relative. The major reason for the 2004 law change was to provide for a uniform definition of a child for purposes of five family tax law benefits: (1) dependency exemption, (2) child tax credit, (3) earned income credit, (4) dependent care credit, and (5) head of household filing status. 14 A qualifying child must satisfy all of the following five tests (requirements): (1) the child has not attained a specified age the child must be under 19, or under 24 if a full-time student, though there is no age limitation for an individual who is totally and permanently disabled; (2) the child cannot provide over 50% of his or her own support (educational scholarships are not included in the support base) this requirement 4

10 is lifted for purposes of the earned income credit; (3) the child has one of the following relationships to the taxpayer: a. Son, daughter, stepson, stepdaughter, or descendant of any of the preceding. b. Brother, sister, stepbrother, stepsister, or descendant of any of the preceding. c. An individual legally adopted by the taxpayer or an individual who is lawfully placed with the taxpayer for legal adoption. d. A foster child who is placed with the taxpayer by an authorized placement agency or by judgment, decree, or other court decree. (4) the child has the same principal place of abode as the taxpayer for more than one-half of the tax year absences due to illness, education, business, vacation, or military service are considered temporary and do not jeopardize meeting this test; and, (5) the child must be a U.S. citizen, or resident of the U.S., Canada, or Mexico, or be an adopted alien. There are tie-breaking rules when a child may be a qualifying child of more than one person. Here are the tie-breaking rules: 1. The child s parent if only one of the individuals who may claim the child as a qualifying child is the child s parent. 2. The child s parent residing with the child if both parents may claim the child. The noncustodial parent may claim the child if the other parent attaches a waiver of exemption to the tax return (filed by the parent claiming the exemption) The child s parent with the higher AGI if the parents have joint custody and it cannot be determined where the child lives the longer time. 4. The taxpayer with the highest AGI - if none of the individuals who may claim the child is the child s parent. 16 With respect to a qualifying relative, a qualifying relative must satisfy all of the following five tests (requirements): (1) gross income test the dependent's gross income must be less than the exemption amount ($3,700 for 2011, $3,800 for 2012); (2) support test the taxpayer must furnish more than 50% of the dependent's support this test is determined on an annual basis, and support includes the sum of lodging costs, the costs for direct items such as food, clothing, education, transportation, medical, and a proportionate share of indirect expenses not included in the lodging amount (the support percentage, thus, can be calculated as follows: taxpayer support / total support expenditures for and by dependents) in the event that no one meets the support test, a multiple support agreement can be filed in which the parties to the agreement elect who will claim the dependent (several requirements must be met when a multiple support agreement is filed: (a) no one person can have contributed more than 50% of the qualifying relative s support; (b) the group of individuals must meet all of the dependency requirements except the support requirement, and together they 5

11 must provide more than 50% of the qualifying relative s support; (c) the eligible "supporter" must have contributed more than 10% of the support; and, (d) each eligible supporter other than the taxpayer claiming the exemption deduction must file a written declaration that he or she will not claim the deduction (the declaration is done using Form 2120)); (3) relationship or residence test the qualifying relative must be one of the following: parent (step) or grandparent, child under age 19 (under 24 if full-time student), niece or nephew, aunt or uncle, in-law, or member of the taxpayer's household the entire tax year (note that a cousin does not qualify unless he/she is a member of the taxpayer's household for the entire tax year); (4) joint return test the qualifying relative must not have filed a joint return with a spouse, though this test is met if the taxpayers were not required to file but they filed in order to obtain the tax payments they made during the year; and, (5) citizenship test the qualifying relative must be a U.S. citizen, or resident of the U.S., Canada, or Mexico, or be an adopted alien. 17 **REVIEW QUESTIONS AND SOLUTIONS** True False Questions 2. For married taxpayers who file a joint return in 2012, their exemption amounts begin to phase out at AGI of $250,200. Solutions 2. False is the correct response. For 2012, there is no phaseout of a taxpayer s exemption amounts. True is the incorrect response. For 2009, the exemption amounts for married taxpayers who filed jointly began to phase out at AGI of $250,200. However, there is no phaseout for C. RETURNS OF MINORS C.1 General Filing Considerations Generally, a single child who may be claimed as a dependent on his/her parents' tax return must file his/her own return if any of the following three conditions is met: (1) the child has more than $950 of unearned income in 2011 or 2012; (2) the child has more than $5,800 ($5,950) of earned income in 2011 (2012); or, (3) the child has total unearned and earned income that is more than the larger of (a) $950 in 2011 or 2012, or (b) earned income up to $5,500 ($5,650) in 2011 (2012) plus $300. Examples of earned income are salaries, wages, tips, professional fees, and other amounts received as compensation for work actually done. Unearned income is income other than earned income. Examples of unearned income are investment income such as interest, dividends, and capital gains. A child filing his/her own return who can be claimed as a dependent on the parent s return is not entitled to a personal exemption, and his / her standard deduction may be limited. 6

12 **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 3. For 2012, a single child who may be claimed as a dependent on her parents tax return must file her own return if she has no unearned income and more than? of earned income. a. $5,650. b. $950. c. $5,950. Solutions 3. C is the correct response. For 2012, if the child has more than $5,950 of earned income and no unearned income, he/she must file her own return. A is an incorrect response. $5,650 is the limit on earned income used in 2012 to determine if the child must file his/her own return when the child has both unearned and earned income. B is an incorrect response. $950 is the threshold amount of unearned income, not earned income, in 2012 which necessitates the child s filing her own return. C.2 Investment Income of Minors The kiddie tax, whereby part of a child's investment income is subjected to tax at the parents' tax rates, applies regardless of whether the child is a dependent. For 2011, if the dependent child has not reached by the end of the taxable year, the child has at least one living parent, the child has investment income (that is, net unearned income) exceeding $1,900, the child is required to file a tax return, and the child does not file a joint return, a special procedure is followed to calculate the tax on his/her taxable income. Since 2008, the special procedure also applies to a full-time student who has not reached 24 by the end of the taxable year, and whose earned income is less than 50% of the student s support. A child is considered 18 on the day before his/her eighteenth birthday. Thus, for 2012, a child who turns 18 on January 1, 2013, is considered 18 by the end of 2012: the kiddie tax would not apply to such a child. 19 Conceptually, the objective of the rule is simple -- to circumvent the taxing of the parents income at the child's lower tax rate. However, the procedure to apply the rule is complex. Form 8615 is used to compute the tax. It is attached to the child's return. A Form 8615 is completed for each affected child TAX SAVER!! These restrictions have certain tax planning implications. First, once the child reaches 18, the kiddie tax no longer poses a problem. Income shifting to children 18 or older generally is not a concern with respect to the kiddie tax (though since 2008 the kiddie tax has applied to a full-time student who is not 24 by the end of the taxable year, and whose earned income is less than 50% of the student s support). Second, for children under 18, their investment income should 7

13 be carefully monitored. Income shifting still is available for them: there simply is a $1,900 limitation in 2011 on the amount of the income which can be effectively shifted. Third, the parent does have an option if the child has more than $1,900 in 2011 of investment income: the parent may make the election to include the child's income that exceeds $1,900 in 2011 on his/her own tax return. Certain conditions must exist before this election may be made Two points about Form 8615 deserve special mention. First, in order to complete it, information about the parents return is necessary. Therefore, the parent's return must be completed before Form 8615 is completed. Second, the procedure employed on Form 8615 essentially follows the following guidelines: (1) the child's net investment income must be calculated (net investment income includes generally all income other than salaries, wages, and amounts received for work actually done, reduced by expenses to produce the income); (2) a tentative tax is calculated on the child's net investment income, based on the parents rate; and, (3) the child's tax is computed. The parent may eliminate the requirement to file Form 8615 by including the child's investment income 20 on his/her own return. In addition to the child's being under 19 (under 24 if a full-time student) at the end of the taxable year (2008 and later), the following conditions must be met with respect to the child in order for this election to be available to the parent: 1. the child's gross income must consist of only dividends and interest; 2. the child's gross income is more than $950 in 2011 and 2012, but less than $9,500 in 2011 and 2012; 3. no estimated tax payments were made in the child s name; 4. no federal income tax was withheld from the child s income; 5. the child is required to file a return; and, 6. the child does not file a joint return. 21 To make this election, the parent must complete Form 8814 and attach it to his/her return. If the parent files a Form 8814, the child does not have to file a return (since the child s only income is investment income, interest and dividends generally, and it is reported on the parent s return). A separate Form 8814 must be filed for each child for whom an election is made. Any interest income which is a tax preference item for the child (that is, tax-exempt interest on private activity bonds) is treated as a tax preference item for the parents TAX SAVER!! From a tax planning standpoint, a parent who would find it advantageous to make this election must monitor several items. First, the parent must ensure that the child receives no income other than dividends and interest: apparently, any compensation received for services, or any capital gain on property disposed of, would preclude this election. Second, amounts of dividend and 8

14 interest income must be monitored: $9,500 or more in 2011 and 2012 would preclude this election. Third, estimated payments and withholding with respect to the child must be considered. Fourth, the parents withholding and/or estimated tax payments must be considered. If enough tax (to cover the income inclusion on the parents return) is not withheld or paid in through estimated payments, the parent could face penalty and interest charges Tax preparers should apprise clients about the limited effectiveness of income-shifting to children who have not reached 18 before the day after the end of the taxable year. Remember that this income-shifting strategy still is effective if the child is at least 18 before the day after the end of the taxable year. Additionally, affected clients should be advised as to the propriety of making the above election TAX SAVER!! In certain circumstances, it may be feasible to shift income-producing property to older children. If the taxpayer follows this strategy, the income which accrues to them will be taxed at their tax rate. Usually their tax rate will be lower than their parents' tax rate. The result is that the tax bill for the family unit as a whole is reduced. In most cases, the taxpayer can reduce the family's tax by giving income-producing assets to older children. This principle also is true in 2011 and 2012 for the first $1,900 of income from assets which have been shifted to children who are under 18 years of age TAX SAVER!! Taxpayers may preserve income-shifting benefits if they transfer the right types of income-producing property to younger children. In this regard, the taxpayer should give incomeproducing property which defers income recognition until the child reaches 18 years of age or older, or which produces tax-exempt income. As an example, if the taxpayer gives children who are under 18 years of age stocks, mutual funds, remainder interests in property, land, tax-exempt bonds and bond funds, closely held stock, and market discount obligations which are not original issue discount obligations, income from these items of income-producing property can effectively be deferred until the child reaches 18 years of age or older, thereby avoiding taxation at the parent s presumed higher marginal tax rate **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 4. Where the kiddie tax otherwise would apply, parents who make an election to include their child s investment income on their joint return must complete and include what form with their return? a. Form b. Form c. Form Solutions 4. A is the correct response. The parent eliminates the child s having to file Form 8615 and compute the kiddie tax by specially electing to include the child s investment income on his/her own return. If the parent makes this election, the parent must complete and attach Form 8814 to the parent s return. B is an incorrect response. Form 8615 is the form that must be attached to the child s return, and on which the kiddie tax is computed, if the parent does not make the special election to include the child s investment income on the parent s return. C is an incorrect response. $1,900 is the amount of child investment income beyond which the kiddie tax rules are invoked for 2011 and 2012, not a form with respect to the kiddie tax. 9

15 D. TAX RATES D.1 Ordinary Income The six tax rates for individual taxpayers for 2011 and 2012 are 10%, 15%, 25%, 28%, 33%, and 35%. The width of the 10% and 15% brackets for joint filers is twice the width of those brackets for single filers. The tax rate schedules for 2011 and 2012 are in the tables below Tax Rate Schedules Tax Taxable Income Bracket Ranges by Filing Status Rate Joint Separate Hd Household Single 10% 0-17, , , ,500 15% 17,001-69,000 8,501-34,500 12,151-46,250 8,501-34,500 25% 69, ,350 34,501-69,675 46, ,400 34,501-83,600 28% 139, ,300 69, , , ,350 83, ,400 33% 212, , , , , , , ,150 35% Over 379,150 Over 189,575 Over 379,150 Over 379,150 Example 3 A married taxpayer files a joint return for She and her husband have taxable income of $160,000. For a 2011 joint return, their federal income tax liability is $32, Their marginal rate is 28%, and their average 2011 tax rate is 20.54% Tax Rate Schedules Tax Taxable Income Bracket Ranges by Filing Status Rate Joint Separate Hd Household Single 10% 0-17, , , ,700 15% 17,401-70,700 8,701-35,350 12,401-47,350 8,701-35,350 25% 70, ,700 35,351-71,350 47, ,300 35,351-85,650 28% 142, ,450 71, , , ,050 85, ,650 33% 217, , , , , , , ,350 35% Over 388,350 Over 194,175 Over 388,350 Over 388,350 10

16 Example 4 The taxpayers in Example 3 have 2012 taxable income of $160,000. For a 2012 joint return, their federal income tax liability will be $ smaller at $32,579. Their marginal rate remains at 28%, and their average 2012 tax rate is 20.36%, down slightly from **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 5. Robin Dickens is a single taxpayer. For 2012, Robin has $90,000 of taxable income. Robin s federal income tax liability for 2012 is: a. $18, b. $18, c. $25, Solutions 5. B is the correct response. Using the 2012 tax rate schedules for single filing status in Section D.1, calculate Robin s 2012 tax as follows: ($8,700 x 10%) + ($26,650 x 15%) + ($50,300 x 25%) + ($4,350 x 28%) = $18, A is an incorrect response. $18, is the amount of tax for a single taxpayer for 2011, using the 2011 tax rate schedules in Section D.1. C is an incorrect response. $25, is the amount of the tax using only Robin s 28% marginal income tax bracket, without regard to taxing earlier amounts of her taxable income at the lower rates in the 2012 tax rate schedule. D.2 Capital Gain Income On May 17, 2006, President Bush signed into law provisions extending the preferential tax rates on dividend income and long-term capital gain income from 2008 to The Tax Relief Act of 2010 extends these rates to 2011 and Another provision in the 2006 tax legislation characterizes as capital the gain or loss from the sale of musical compositions or copyrights in musical rights sold by the creator in a tax year 23 that begins after May 17, A capital gain or loss results from the sale or exchange of a capital asset. If the capital asset has been held for one year or less, capital gain or loss is short-term. If the capital asset has been held for more than one year, capital gain or loss is long-term. 11

17 Short-term capital gain is taxed the same as ordinary income. However, short-term capital gain may offset capital losses without limit. For , long-term capital gain is taxed at 0% for individual taxpayers in the 10% and 15% marginal income tax brackets (formerly 5% for tax years), and 15% for other individual taxpayers. There are two instances where the general rule (0% or 15%) for taxing long-term capital gain does not apply. In one instance, certain property, labeled 28% property, produces gains that are taxed at a maximum 28% rate. The following properties are examples of 28% property: collectibles (for example, works of art, 24 antiques, and gems), and the taxable half of the gain on the sale of qualified small business stock. The 28% rate applies only to taxpayers who are in an income tax bracket greater than 25%. Taxpayers in less than the 28% bracket pay tax on 28% property at their marginal income tax rate. Another instance where the general rule does not apply is for gains on depreciable real estate that has been held more than one year. Gains on this property (for example, apartments, office buildings, and shopping centers) are called "unrecaptured Section 1250 gain." These gains are taxed at a maximum 25% rate. Taxpayers in less than the 25% bracket pay tax at their applicable rate, and taxpayers in brackets greater than 15% pay a maximum 25% rate on "unrecaptured Section 1250 gain." When calculating the taxpayer's net capital gain, the amount of capital gain income that is treated as 25 investment income for purposes of the investment interest expense limitation is not included. That is, it is treated as ordinary income and it is subject to the taxpayer's marginal tax rate rather than the capital gain tax rate. This treatment also will apply to dividends that are taxed at the reduced rates. Bottom line: capital gain income and dividend income are not included in investment income, for purposes of the investment interest expense limitation, unless the taxpayer elects to have them taxed at the taxpayer's regular marginal income tax rates. Example 5 During 2012, Jake Darwin has $5,000 of interest income, $25,000 of long-term capital gain income, $20,000 of investment interest expense, and no investment-related expenses. Jake's other income is $400,000, putting him in the 35% marginal tax bracket. If Jake makes no election to include any capital gain income as investment income, his investment interest expense deduction is 12

18 $5,000 (limited to net investment income of $5,000). The excess interest ($15,000) is carried forward to All $25,000 of long-term capital gain income will be subject to a maximum tax rate of 15%. If he makes an election to include $15,000 of long-term capital gain income as investment income, his investment interest expense deduction is $20,000 ($5,000 + $15,000). However, $15,000 of the capital gain is subject to a 35% tax rate, and $10,000 of the capital gain is subject to a 15% tax rate TAX SAVER!! Because of the maximum tax rate of 15% for net capital gain income, the election for treatment of capital gain income is a more complicated election to assess, especially due to the preferential rate that applies to taxation of dividends. While a greater interest expense deduction will result from the election, the loss in tax savings attributable to the capital gain rates could be 20% for an individual taxpayer in the top marginal tax bracket (35% versus 15%) If a noncorporate taxpayer has net capital gain, long-term capital gains and losses are separated into three tax rate groups: (1) 28% group, (2) 25% group, and (3) 15% group. Gains and losses are netted within each group to arrive at a net gain or loss for each group. 26 The gains and losses from each rate category first are netted within the rate groups and any net losses from a particular rate group are applied first to offset gains in the highest long-term tax rate group (e.g., a net loss for the 15% group would be used to offset a net gain from the 28% group, followed by the 25% group and succeeding groups). Unrecaptured IRC Section 1250 gain is defined as the gain from real estate attributable to depreciation deductions based on the straight-line method of depreciation less the net loss from capital assets included in the 28% rate group. D.3 Dividend Income For individual taxpayers, the rates that apply to dividend income are the same rates that apply to longterm capital gains. For eligible dividends that an individual receives from January 1, 2003, through 2012, the same rates that apply to long-term capital gain also apply to dividends: the top rate on dividend income is 15%, with a 0% rate for applying to individuals who are in the 10% or 15% marginal income tax brackets. Eligible dividends include dividends that are received from domestic corporations and qualified foreign corporations. A qualified foreign corporation includes a corporation that is incorporated in a United States 13

19 possession. The reduced rates are with respect to dividends. Thus, interest income still is subject to the normal income tax rate structure. The reduced rates do not apply to a dividend that is part of the inside taxfree buildup in a qualified retirement plan. So, as an example, a distribution from a Section 401(k) plan, though some part of the distribution may be attributable to dividend income received inside the Section 401(k) plan, nevertheless is taxed at ordinary income tax rates. Certain dividends do not qualify for the lower rate. Here are some examples of dividends that do not qualify: (1) a dividend on stock where the shareholder does not hold the stock for more than 60 days during the 120-day period that begins 60 days before the ex-dividend date; (2) a dividend from a tax-exempt organization; (3) a dividend paid by a credit union or a mutual insurance company; and, (4) a deductible dividend that is paid on employer securities. The lower dividend rates apply only to qualified dividends. Payments in lieu of dividends are not qualified dividends. Payments in lieu of dividends to individuals arise in connection with brokers and dealers who engage in securities lending transactions, short sales, or other similar transactions on behalf of their customers in the normal course of their trade or business. The IRS provides guidance on qualified dividends. 27 **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 6. The lowest rate on dividend income for 2012 is: a. 0%. b. 15%. c. 5%. Solutions 6. A is the correct response. For 2008 through 2012, 0% is the lowest rate that applies to dividend income. B is an incorrect response. For , taxpayers with a marginal rate more than 15% pay a 15% rate on dividend income, the highest rate on dividend income. C is an incorrect response. From , 5% was the lowest rate that applied to dividend income. 14

20 E. CHILD TAX CREDIT E.1 General Rules There is a $1,000 tax credit per child for taxpayers with one or more qualifying children. The $1,000 credit applies through Generally, the same relationships that are used in the uniform definition of a child for purposes of the dependency exemption are used to define an eligible child for purposes of the child tax credit. However, there is an age modification: the child must not have reached age 17 by the end of the tax year. The rules for temporary absence, relationship, and tie-breaking situations that apply for purposes of the earned income credit also apply for purposes of the child tax credit. For divorced or separated parents, the special rules that give the child s dependency exemption to the noncustodial parent also give rights to the child tax credit to the noncustodial parent. 29 The child must be a United States citizen, national, or resident. The taxpayer may not take the child tax 30 credit in a short tax year, unless the short tax year is due to the taxpayer's death. The taxpayer must include the child's name and taxpayer identification number (TIN) on his/her tax return. If the taxpayer omits the child's TIN, the IRS may deny the credit under the summary assessment procedure. 31 The credit is phased out in $50 increments for each $1,000 (or fraction of $1,000) of "modified adjusted gross income" (MAGI) above a threshold amount. MAGI is AGI increased by any foreign income exclusion, 32 foreign housing exclusion, and any income excluded for a bona fide resident of Guam, American Samoa, 33 or the Northern Mariana Islands, or a resident of Puerto Rico. The threshold amount depends on filing status: $110,000 for married taxpayers filing jointly, $55,000 for married taxpayers filing separately, and $75,000 for other individual taxpayers. 34 Example 6 Jonathan Dixon and his wife Katrina have two children. For 2011, the Dixons' children are 15

21 13 and 16. The Dixons claim personal exemption deductions for them, and they file jointly. Their 2011 MAGI is $125,000. Their 2011 child tax credit is $1,250 [($1,000 x 2) - ((($125,000 - $110,000) / $1,000) x $50)]. Example 7 For 2012, the Dixons' children are 14 and 17. They still can claim personal exemption deductions for them, and they file jointly. Their 2011 MAGI is $135,000. Their 2012 child tax credit is 0. Their initial credit is $1,000 for one child -- the Dixons do not qualify for the child tax credit with respect to the 17-year old. The $1,000 amount is phased out because of the size of their 2012 MAGI [$1,000 - ((($135,000 - $110,000) / $1,000) x $50)]. MAGI amounts in excess of the following amounts cause the child tax credit to be eliminated: Filing Status 1 Child 2 Children 3 Children Married Joint Return $129,000 $149,000 $169,000 Single/Head of Household $ 94,000 $114,000 $134,000 Example 8 Bill and Joan file a joint return in 2012 and have two children under age 17 who qualify for the child tax credit. Their 2012 MAGI is $129,500. Their excess MAGI is $19,500 ($129,500 - $110,000), resulting in the loss of $1,000 of tax credit. They have 19.5 ($19,500/$1,000) $1,000 increments which is rounded up to 20. Thus, they lose $1,000 (20 x $50) of the child credit and have a remaining credit of $1,000 ($2,000 - $1,000). The child tax credit is in addition to the dependency exemption for children. The credit is not indexed for inflation. There is a special rule used to compute the credit for taxpayers who have at least three qualifying children. 35 A portion of the child tax credit is refundable. This refundability feature applies to all taxpayers, regardless of the amount of the taxpayer s regular tax or alternative minimum tax liability. Also, the taxpayer may claim the nonrefundable portion of the child tax credit against both regular tax liability and alternative minimum tax liability. For , the child tax credit is refundable to the extent of 15% of the 36 taxpayer s earned income in excess of $3,000. Military families may elect to include combat zone pay (which otherwise is excludable income) in their earned income to calculate the refundable portion of the child tax credit. The refundable portion of the child tax credit reduces the nonrefundable portion. The taxpayer files Form 8812, Additional Child Tax Credit, to claim the refundable portion of the child tax credit. 16

22 E.2 Phaseout of Child Tax Credit The amount of the taxpayer s child tax credit is reduced once the taxpayer s MAGI reaches a certain 37 level, one of two limitations on the amount of the credit that is available. The other limitation is the tax liability limitation. The child tax credit can offset both regular tax and alternative minimum tax liability. However, it is limited to the excess of those liabilities over the sum of all nonrefundable personal credits and the foreign tax credit. The credits include only certain nonrefundable personal credits and the foreign tax credit. For purposes of the MAGI limitation, recall that MAGI is AGI plus amounts excluded from income under certain international exclusion provisions. So, for many taxpayers the MAGI limitation is effectively an AGI limitation. Any strategies that reduce AGI enhance the likelihood and amount of the child tax credit. In this respect, the taxpayer should consider the potential effectiveness of deferring income and/or accelerating deductions. Since the number of children under age 17 determines the amount of the initial credit ($1,000 x the number of children under age 17), and the reduction in the initial credit is $50 for each $1,000 or fraction thereof of the taxpayer s MAGI over a threshold amount, the number of children also determines the MAGI level at which the child tax credit is phased out completely for the taxpayer. Except for a short tax year caused by the taxpayer s death, a short tax year prevents the taxpayer from using the child tax credit. In this regard, if the facts and circumstances otherwise would permit a delay, if the taxpayer anticipates changing his or tax year, and there still are children under age 17 at home, he or she might want to consider delaying the tax year change. **REVIEW QUESTIONS AND SOLUTIONS** Multiple Choice Questions 7. Dale and Mildred White file a joint return for The Whites have MAGI of $135,000. The Whites have two children: one is 14 years of age, the other is 16 years of age. How much is the Whites 2012 child tax credit? a. $-0-. b. $ 750. c. $2,

23 Solutions 7. B is the correct response. The Whites potential child tax credit is $2,000 ($1,000 x 2 children under age 17). Their MAGI of $135,000 exceeds the $110,000 threshold amount for joint filers by 25 $1,000 increments. So, $1,250 (25 x $50) of their $2,000 potential child tax credit is phased out, leaving $750 of actual child tax credit. A is an incorrect response. The Whites potential child tax credit of $2,000 for two children is not completely phased out until their MAGI exceeds $149,000: their $135,000 of MAGI is less than $149,000. C is an incorrect response. $2,000 is the maximum amount of the potential child tax credit for the Whites. Because their MAGI of $135,000 exceeds the $110,000 threshold amount, but is less than the $149,000 of MAGI above which the child tax credit is completely phased out for joint filers with two children, they are entitled to some of the potential $2,000 child tax credit available to them. F. DEPENDENT CARE CREDIT F.1 General Rules 38 The dependent care credit is a nonrefundable credit. It is based on expenses for dependent care services that are incurred by the taxpayer so that he or she can be gainfully employed. The maximum credit percentage 39 is 35%, and it is reduced by 1% for each $2,000 or fraction thereof by which the taxpayers s AGI exceeds $15,000. Thus, there is a 20% credit percentage floor which applies to taxpayers with AGI exceeding $43,000. Expenses include those for household services and for the care of a qualifying individual. The cost of day camp may qualify, but fees for overnight camp do not qualify. Payment for services outside of the home qualify, if the services involve the care of a qualified child or a disabled spouse or dependent who regularly spends at least eight hours a day in the taxpayer s home. Expenses are limited to the earned income of a single taxpayer, and the lower income for married taxpayers who file a joint return (the credit is not available to married taxpayers who do not file jointly). There are special rules for the income of a spouse who is a full- 40 time student. Further, expenses that qualify for the credit are limited to $3,000 for one qualifying individual, 18