Credits. OVERVIEW OBJECTIVES

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1 14 Credits OVERVIEW This chapter will show you that credits are valuable tax savers. In Chapter 3, you learned about the Child Tax Credit. In Chapter 10, you learned about the Earned Income Tax Credit. In this chapter, you will learn about other credits that may be claimed on Form 1040A. One common credit is the Child and Dependent Care Credit. Another credit that is less common, but still important to be familiar with, is the credit for the elderly and disabled. Lastly, the premium tax credit (PTC) will need to be considered on every tax return that you prepare. Education credits will be covered in Chapter 16. OBJECTIVES At the conclusion of this chapter, you will be able to determine the eligibility and calculations for the: Child and Dependent Care Credit, and compute the credit. Credit for the elderly or disabled. Premium tax credit (PTC). TAX TERMS Look up the definitions of the following terms in the glossary: Advance of the premium tax credit (APTC). Affordable Care Act (ACA). Benchmark Premium. Bronze/Silver/Gold/Platinum plans. Cafeteria plan. Child and Dependent Care Credit. Coverage family. Credits. Department of Health and Human Services (HHS or DHHS). Excess advance premium tax credit. Federal poverty level (FPL). Limitation on premium tax credit repayment. Marketplace/Exchange. Net premium tax credit. Nonrefundable credit. Open enrollment period. Qualified health plan. Refundable credit. Saver s Credit. Shared responsibility payment. 14.1

2 14.2 H&R Block Income Tax Course (2016) CREDITS VS. DEDUCTIONS Before we begin this discussion of credits, it is important to review the difference between credits and deductions. While both credits and deductions help taxpayers reduce the amount of tax they must pay, they do so in different ways. Deductions, such as the standard deduction or itemizing deductions, lower the tax by reducing the amount of income that would otherwise be taxable. Lower taxable income results in a lower tax liability. Unlike deductions, credits do not come into play until after taxable income has been computed and the tax determined. Then, credits may be used to reduce the tax already determined dollar for dollar. Some credits are nonrefundable, and some are refundable. Nonrefundable means that the combined amount of these credits cannot reduce the taxpayer s tax liability below zero. Refundable credits may reduce the taxpayer s tax liability below zero, and the difference is refunded to the taxpayer. CHILD AND DEPENDENT CARE CREDIT Single parents and two-career couples must find ways to care for their young children while they work. The Tax Code provides a way for such parents to recoup some of their expenses for child care through a nonrefundable tax credit. This credit is also available to taxpayers caring for disabled dependents and spouses. Study page 1 of Form 2441 in Illustration 14.1 on page A taxpayer who incurred and paid expenses for the care of a qualifying person while they worked or searched for work may be entitled to a tax credit based on the amount paid during the year for those services. Requirements To claim the Child and Dependent Care Credit, the taxpayer must meet the following requirements: Married taxpayers generally must file a joint return (but see Married taxpayers on the next page). The care must have been provided so the taxpayer (and the spouse, if married) could work or look for work. The taxpayer must have some earned income. Taxpayers who are married and are living together both must have earned income (unless one spouse was a student or disabled, as explained later). The taxpayer and the person(s) for whom the care was provided must have lived in the same home. The person who provided the care must not be someone the taxpayer can claim as a dependent. Services provided by the taxpayer s child under age 19 do not qualify, even if the provider is not a dependent.

3 Credits 14.3 Married taxpayers who meet the following requirements may claim the credit even if not filing a joint return: The taxpayer paid over half the cost of maintaining a household for the year, which was the principal residence of both the taxpayer and a qualifying person for more than half the tax year. During the last six months of the tax year, the taxpayer s spouse was not a member of the household. Qualifying Persons To claim a credit for qualified expenses (defined below), the care must have been provided for one or more qualifying persons. Qualifying persons include: A dependent who is a qualifying child and has not reached their 13th birthday when the care was provided. Note: For purposes of this credit, the child is considered to have attained the age of 13 on their birthday, not the day before. Generally, the taxpayer must be entitled to claim a dependency exemption for the child, but an exception applies for children of divorced or separated parents. The taxpayer s spouse who is physically or mentally incapable of self-care and lived with the taxpayer for more than half of A disabled person of any age who is physically or mentally incapable of self-care, lived with the taxpayer for more than half of 2015, and whom the taxpayer claims as a dependent or could claim as a dependent except that: The disabled person had gross income of $4,000 or more. The disabled person filed a joint return. The taxpayer (or their spouse if filing jointly) could be claimed on another taxpayer s 2015 return. Exception: In cases of divorced or separated parents, the child will be the qualifying child of the custodial parent for purposes of this credit, even if the noncustodial parent claims the dependency exemption for the child. Qualified Expenses Qualified child or dependent care expenses are those incurred for the primary purpose of assuring the well-being and protection of a qualifying person while the taxpayer works or looks for work. Expenses for care provided outside the home for the qualifying child, disabled dependent, or disabled spouse can be counted, provided the qualifying person regularly spends at least eight hours each day in the taxpayer s home. If the care is provided in a dependent care center (one that cares for more than six persons for a fee), the center must comply with all relevant state and local laws. Certain expenses do not qualify for the Child and Dependent Care Credit. The cost of transportation to and from the child care facility does not qualify, and neither do overnight camp expenses. Also, any expense allocable to the education of a child in kindergarten or higher does not qualify. The total cost of schooling below kindergarten qualifies only if the cost of schooling cannot be separated from the cost of care.

4 14.4 H&R Block Income Tax Course (2016) mexample: June and Henry Stark both work. Their son, Harry, attends first grade at a private school. After school, the Starks pay to have Harry transported to a child care center, where they pick him up after work. The expenses for the private school and the transportation do not qualify for the Child Care Credit. The amount they pay the child care center does qualify. If Harry were in an all-day preschool setting where educational activities were part of the child care service, the entire cost would qualify for the credit.m Expenses for in-home care of a qualifying child, disabled dependent, or disabled spouse also qualify for the credit. Qualified expenses for in-home care may include amounts paid for cooking and light housework related to the care of a qualifying individual as well as actual care. Amounts paid for chauffeur or gardening services do not qualify. Total qualified expenses include gross wages paid for qualified services, plus the cost of meals and lodging furnished to the employee, plus the employer s social security, medicare, FUTA (federal unemployment), and any other payroll taxes paid on the wages. See the discussion of Schedule H later for more information about paying employment taxes for household help. A taxpayer who hires a household worker and pays wages of $1,900 or more during the year to that worker must pay the employer s share of social security and medicare taxes. Remember, payments to any of the following do not qualify for the credit: A person who either the taxpayer or the spouse may claim as a dependent. The taxpayer s child who is under age 19. An overnight camp. Complete Exercise 14.1 before continuing to read. Computing the Credit The Child and Dependent Care Credit for 2015 is a percentage of the smallest of the following: The amount of qualified expenses incurred and paid during the year. $3,000 for one qualifying individual or $6,000 for two or more qualifying individuals. The taxpayer s earned income (defined later) for the year or, for married taxpayers filing jointly, the earned income for the year of the spouse earning the lesser amount. The lines on Form 2441 are, for the most part, self-explanatory. Those that require a bit of added explanation are discussed below. Line 1. Taxpayers must report the care provider s name, address, and identifying number (the social security number for an individual or the employer identification number for a business). If the care provider is a tax-exempt organization (a church, for example) and they do not provide a number, enter Tax-exempt in column (c). Enter the total amount actually paid to each institution or individual in column (d). The IRS provides Form W-10 to assist taxpayers in obtaining information from child care providers. The taxpayer should direct the provider to complete Form W-10 or a similar document to provide the necessary information to the taxpayer.

5 Credits 14.5 The IRS can use the information on line 1 to match what the taxpayer paid the care provider with the amount the care provider reports as income on their tax return. Therefore, all amounts actually paid to the care provider (by the taxpayer, their employer, or anyone else) during the year must be entered. Any amounts incurred, but not yet paid, would not be reported on line 1. If the taxpayer pays social security, medicare, and other payroll taxes for a child care provider s services within their home, those amounts would not be listed on line 1, because they were not actually paid to the child care provider. These amounts would, however, be entered as part of the total qualified expenses for each qualifying person in column (c), line 2. mexample: Carol Cruz hired Michelle Garner to come to her home to care for her five-year-old son while Carol worked. She paid Michelle $2,000 during the year. In addition, Carol paid the federal government $153 as the employer s share of social security and medicare taxes. Carol should enter only $2,000 in column (d), line 1, because that s the amount that is income to Michelle, even though the full $2,153 expense qualifies for the Child and Dependent Care Credit and would be entered in column (c), line 2.m Line 2. On this line, enter the name and social security number of each qualifying person for whom care was provided, as well as the amount incurred and paid during the taxable year for the care of each person. If there are more than two qualifying persons, attach a statement. The amount on this line could be more than the amount on line 1, as seen in the Carol Cruz example above. It could also be less than the amount on line 1, as in the following example. mexample: Bess and Jim Franklin paid Betty Gessell $1,200 to look after their three-year-old daughter, Margaret. They took Margaret to Betty s home. Of that amount, $1,000 was for expenses incurred in 2015, and $200 of that amount was for expenses incurred in December 2014 that they paid in January The Franklins should enter the full $1,200 on line 1, column (d), and $1,000 on line 2.m Often, the total of the amount on line 1 and the amount on line 3 (the total of the line 2 amounts) will be the same, but not always, as illustrated in the examples above. Also, line 3 cannot exceed the maximum amount ($3,000 for one qualifying individual or $6,000 for two or more qualifying individuals). Another situation where the amount on line 3 might not be the same as the total from line 1 is if the taxpayer s employer paid any portion of the child care expenses and excluded the amount from income. In such a case, the taxpayer must complete Part III on the second page of the form. The amount to be entered on line 3 is determined in that section of the form. We will defer discussion of these benefits for the moment, and return to them in the next section. Line 4. Enter the primary taxpayer s earned income on line 4. The primary taxpayer is the one named first in the heading on the first page of the tax return. Earned income includes taxable salaries, wages, tips, strike benefits, other employee compensation, disability income reported as wages, and net income or loss from self-employment. Earned income does not include nontaxable employee compensation (like 401(k) contributions), pensions and annuities, social security and railroad retirement benefits, workers compensation, nontaxable scholarships or fellowship grants, nontaxable workfare payments, income of nonresident aliens that is not derived from a U.S. business, or income received for work while an inmate in a penal institution.

6 14.6 H&R Block Income Tax Course (2016) Taxpayers have a choice when it comes to nontaxable combat pay. They can elect to treat it as earned income for the Child and Dependent Care Credit just as they can for the Earned Income Credit. The credit should be figured both ways to determine which way gives the greater tax benefit. Line 5. If the taxpayer is filing a joint return, enter the spouse s earned income on line 5. Otherwise, enter the amount from line 4 on line 5. Student or disabled. If the taxpayer or the spouse was disabled or was a qualified full-time student, multiply the number of months the taxpayer or spouse met such a condition by $250 ($500 if two or more qualifying persons are listed on line 2). Add the result to any earned income from other months, and enter the total on line 4 or 5. Only one spouse may use this adjustment in any given month. mexample: Wallace and Lena Birch file jointly. Wallace was disabled and incapable of self-care during He received social security benefits, but received no earned income. Lena was a full-time student through May, and she worked part-time through the end of the year, earning $8,000. The remainder of their income was from investments. Lena paid a nurse to care for Wallace while she went to school and worked. Wallace s earned income on line 4 will be $3,000 [$ months disabled]. Lena s earned income on line 5 will be $8,000. Because Wallace used this adjustment every month, Lena may not use it for the months she was a student; but in this case, it does not matter because she has sufficient earned income.m Credit Limitation The taxpayer s Child and Dependent Care Credit is limited to their tax liability; any excess is lost. With certain credits, like the Child Tax Credit or adoption credit, the excess may be refundable. However, this is not so for the Child and Dependent Care Credit. Line 10. Taxpayers using Form 1040A will enter the tax liability from Form 1040A, line 30. mexample: Mary Cubby s tentative Child Care Credit on Form 2441, line 9, is $960. However, her tax liability on Form 1040A, line 30, is only $693. She will enter $693 on Form 2441, line 10. Her credit on line 11 will be limited to the lesser of line 9 or line 10.m Note: If the taxpayer paid qualified expenses in 2015 that were incurred in 2014, they must figure that portion of the credit using Worksheet A, Worksheet for 2014 Expenses Paid in 2015, in Publication 503, Child and Dependent Care Expenses. Add the amount from the worksheet to the 2015 credit. Such a taxpayer should add the marginal notation CPYE, the name and social security number of the person for whom the expenses were paid, and the amount of the credit based on prior-year expenses above line 9. Employer-Provided Benefits Some employers provide on-site child care for their employees children. Others pay directly for third-party child care or allow employees to reduce their salaries and save the reduction in accounts (described below) specifically earmarked to pay for child care expenses. In these cases, the value of the child care or the amount paid by the employer or from the account is not reported to the employee as taxable income. Section 125 plans (also called cafeteria plans or flexible spending accounts) are salary reduction arrangements offered by some employers. These plans allow employees to reduce their salaries by a

7 Credits 14.7 certain amount in return for one or more nontaxable benefits. A common example is a flexible spending account (FSA) used to pay child care expenses or medical expenses. If the employer did not include such amounts in taxable income, the taxpayer must reduce the amount of expenses eligible for the credit by the amount excluded from income. The amount of child or dependent care benefits (DCB) is shown in box 10 of Form W-2. When a taxpayer s W-2 shows dependent care benefits, they must complete Part III of Form 2441, even if they are not claiming any Child Care Credit. Part of the benefits provided by the employer may not be excludible. If the benefits provided by the employer exceed the smallest of (1) the amount of qualified expenses, (2) the lesser of the taxpayer s or the spouse s earned income, or (3) $5,000 ($2,500 MFS), the difference is taxable (see Form 2441, line 26). Any taxable amount should be added to the taxpayer s wages entered on 1040A, line 7, and the letters DCB written to the left of line 7. mexample: Becky A. Marshall files as head of household. During 2015, the Tiny Tot Center charged Becky $2,000 to care for her two-year-old son, Dylan, while she worked. Her employer paid $500 of the cost of the child care and entered that amount in box 10 of her Form W-2. Becky paid the other $1,500 herself. Becky s earned income and adjusted gross income (Form 1040A, line 21) are both $31,600. Her Form 2441 is shown in Illustrations 14.1 and 14.2.m Most of the entries on Becky s Form 2441 are self-explanatory, but some further explanation may be helpful. First, consider the order in which the form should be completed. One would logically expect to complete Part I first, then Part II, and so on; but think again. In this case, because Becky received employer-provided dependent care benefits, she first completes Part I, then Part III, and then Part II. Lines 2 and 3. Even though the Tiny Tot Center received $2,000 for caring for Becky s son while she worked, only $1,500 is entered on line 2, because excluded benefits do not count toward the credit. The figure on line 3 comes from Part III, line 31, on page 2. Line 16. This line shows the amount of qualified expenses incurred, the total of line 1, column (d). Notice that it differs from the amount on line 2, which had to be reduced by the excluded benefits. Lines 19 and 20. The definition of earned income, for purposes of the exclusion, is similar to that of the credit. Do not include the dependent care benefits shown on line 12 or any other nontaxable earned income. However, the taxpayer may elect to include nontaxable combat pay in earned income. Line 22 asks if any amount on line 12 is from a sole proprietorship or partnership. If so, enter the amount here. If not, enter zero. Line 24 is used by those self-employed individuals who file Form 1040 and deduct benefits on Schedules C, E, or F. Line 25. Becky is able to exclude from income all of her benefits from her employer. She has no taxable DCB to enter on Form 1040A, line 7. To summarize: Employer-provided benefits for dependent care that are shown in box 10 of a taxpayer s Form W-2 must always be entered on Form 2441 to determine the excludible amount. If the taxpayer is claiming the Child and Dependent Care Credit, the excluded benefits reduce the qualified expenses eligible for the credit. If the total benefits exceed the allowable excludible amount, the balance is entered as taxable income on 1040A, line 7, with the marginal notation DCB.

8 14.8 H&R Block Income Tax Course (2016) Illustration 14.1

9 Illustration 14.2 Credits 14.9

10 14.10 H&R Block Income Tax Course (2016) Complete Exercises 14.2 and 14.3 before continuing to read. CREDIT FOR THE ELDERLY OR THE DISABLED This is a seldom-used credit, because it has not been indexed for inflation since 1985, and the income limits are very low. Income includes nontaxable social security over $5,000 or other nontaxable pensions. Taxpayers might qualify for this credit if either of the following applies: 1. They re age 65 or older. 2. They re under age 65, and they (all of the following apply): Retired on permanent and total disability. Received taxable disability benefits. Have not reached mandatory retirement age (the age when their employer s retirement program would require them to retire). Taxpayers who pass the age or disability test must also fall below the limits set for their filing status to claim this credit. TAXPAYERS WHO ARE: Single, head of household, or qualifying widow(er). Married filing jointly and only one passes the age or disability test. Married filing jointly and both pass the age or disability test. Married filing separately and lived apart from spouse for the entire year. GENERALLY CANNOT TAKE THE CREDIT IF: Their AGI is: Or they received: $17,500 or more $5,000 or more of nontaxable social security or other nontaxable pensions, annuities, or $20,000 or more disability income. $25,000 or more $7,500 or more of nontaxable social security or other nontaxable pensions, annuities, or disability income. $12,500 or more $3,750 or more of nontaxable social security or other nontaxable pensions, annuities, or disability income. mexample: Agatha Humphrey is 70 years old and received $13,500 from a taxable pension and $1,500 in nontaxable social security income. From this example, you can see how low the income limits are to receive the small credit. Agatha s Schedule R is in Illustrations 14.3 and 14.4.m

11 Illustration 14.3 Credits 14.11

12 14.12 H&R Block Income Tax Course (2016) Illustration 14.4

13 Credits BlockWorks Tip: The software has been programmed to automatically generate Schedule R and calculate the credit when the taxpayer meets the qualifications for the Credit for the Elderly or the Disabled. PREMIUM TAX CREDIT On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act. There are various tax implications associated with the Affordable Care Act (ACA), most of which pertain to more complicated tax returns. The provision that we will cover in this course is the individual mandate, which states that, beginning in January 2015, most U.S. citizens and residents are required to have qualified health insurance coverage, qualify for an exemption, or be subject to the ACA tax penalty. As it applies to income tax returns, ACA requires all taxpayers to state whether or not they had qualified health insurance for themselves and their tax household for every month in The premium tax credit (PTC) is a credit that helps pay the cost of coverage through the Marketplace. It is either advanced to the taxpayer or refunded through their income tax return. It is important that you understand the basics of ACA compliance so that you can conduct a tax interview that correctly applies the premium tax credit. Eligibility Taxpayers are eligible for the PTC if they meet all of the following requirements: Purchase coverage through the Marketplace and all applicable enrollment premiums (for which they were responsible to pay) are paid by the due date of the tax return (not including extensions). Are a U.S. citizen or lawfully-admitted resident. Have household income for their family size that is 100% through 400% of the federal poverty level (FPL) in states where Medicaid was not expanded. It is effectively 139% through 400% of FPL in states where Medicaid was expanded. There are three FPL charts: one for the 48 contiguous states plus the District of Columbia, and separate ones for Alaska and Hawaii. If a taxpayer moves during the year, or if spouses live in separate states and more than one chart would apply, the chart listing the highest amount is used. Are not eligible for affordable coverage through an employer-sponsored plan. Coverage is considered affordable if it does not exceed 9.5% of household income for self-only coverage. For this purpose, any additional cost for family coverage is not considered. Are not eligible for coverage through a government program, such as medicare, Medicaid, TRICARE, CHIP, etc.

14 14.14 H&R Block Income Tax Course (2016) Do not file a married filing separately tax return. An exception is available to certain victims of domestic abuse and spousal abandonment. Cannot be claimed as a dependent by another person. Tax Household The individual mandate of ACA requires taxpayers to state, through their tax return, whether they and everyone in their tax household had qualified health insurance for the tax year. Tax household includes everyone for whom an exemption is claimed on the tax return and anyone for whom the taxpayer could have claimed an exemption, but did not. mexample: Miki (34) is a paralegal. She is not married and does not have any children. She shares a condominium with her brother, Alec (28), who works in construction. Alec is not married and does not have any children. Miki has one Form W-2 with $48,000 wages, and files single using Form 1040-EZ. Alec also has one Form W-2 with $47,000 wages, and files single using Form 1040-EZ. Even though Miki and Alec share a residence, their tax households consist only of themselves. Miki s tax household is herself only. Alec s tax household consists of himself only.m mexample: Manuel (23) works in food service. Manuel and Leticia (25) are the unmarried parents of Lucas (2). Manuel shared an apartment all year with Lucas and Letitia. Leticia has no income. Manuel has two Forms W-2 and files head of household claiming both Lucas and Letitia as dependents using Form 1040A. Manuel s tax household consists of himself, his son, Lucas, and Lucas s mother, Letitia.m mexample: Taylor (47) works as a teacher. She is not married and has two children, Francis (20) and Regina (16). Taylor owns a townhouse where Francis and Regina live. Francis is a full-time student at the local college and works part-time as a tutor. Regina is a high school student and works part-time in retail. Neither Francis nor Regina pay more than half of their own support. Taylor files as head of household claiming Regina as her dependent using Form 1040A. Taylor chooses not to claim Francis, so that she may claim her own education expenses. Even though Taylor does not claim Francis on her tax return, she is eligible to do so. Taylor s tax household consists of herself and both her children, Francis and Regina.m Complete Exercise 14.4 before continuing to read. Qualified Health Insurance Taxpayers and people in their tax household usually have qualified health insurance through one of the following: Employer-sponsored coverage. Government program. Marketplace. Direct through the individual market.

15 Credits Qualified health insurance provides minimum essential coverage to its beneficiaries. Coverage through any of the plans listed above will generally comply with the individual mandate. The following plans do not provide minimum essential coverage: Stand-alone coverage for vision care, dental care, accident, disability, or worker s compensation. Coverage in the following TRICARE and Medicaid programs: Optional coverage of family planning services. Optional coverage of tuberculosis-related services. Coverage under pregnancy-only Medicaid. Coverage limited to treatment of emergency medical conditions. Coverage for medically needy individuals (also referred to as spend-down). Coverage authorized under 1115(a)(2) of the Social Security Act (Medicaid demonstration projects). Coverage that is solely limited to space availability in a facility of the uniformed services for individuals excluded from TRICARE coverage for care from private sector providers (also called space available TRICARE coverage). Coverage for an injury, illness, or disease incurred or aggravated in the line of duty for individuals who are not active duty (also called line of duty TRICARE coverage). Note: Although the plans listed in the chart above do not provide minimum essential coverage, taxpayers who have any of these coverages will be able to claim an exemption from the ACA penalty (more information on this later). Monthly Coverage Coverage is determined every month, so it is possible that there are various scenarios. mexample: Christopher (45) was an employee at a printing company in January 2015 and had coverage through his employer. He was laid off in mid-may. Christopher was eligible to purchase COBRA coverage, but chose not to purchase it. Christopher was also eligible to purchase coverage through the Marketplace because he had a qualifying event, but was unaware of the option. Christopher began working at a grocery store in mid-september and once again had coverage through his employer effective on October 1. In this example, Christopher has qualified coverage for eight months (January through May at the printing company and October through December at the grocery store) and no coverage for four months (June through September). Christopher may have to pay the ACA tax penalty unless he qualifies for an exemption, to be discussed later.m mexample: Raquel (29) works at a hotel. She is unmarried and has two children, Anna (3) and Jeremy (8). In January 2015, Raquel did not have health insurance coverage because her employer did not offer coverage to its employees and she believed she could not get coverage any other way. However, Raquel made sure that her children had coverage through the Children s Health Insurance Plan (CHIP).

16 14.16 H&R Block Income Tax Course (2016) When Raquel had her 2014 tax return prepared at H&R Block and was directed to the health care portal by her Tax Professional, she purchased health insurance through the Marketplace with coverage beginning in March In this example, the tax household consists of Raquel and both of her children. Raquel has qualified coverage for ten months and no coverage for two months (January through February). The children had qualified coverage for all 12 months. Raquel may have to pay an ACA tax penalty unless she qualifies for an exemption, to be discussed later.m mexample: Warren (57) and Emily (56) Bixby are married and file a joint return. They have four adult children who do not reside with them. Warren is self-employed, and in January 2015 had coverage he purchased directly from an insurance broker. In March 2015, he learned that he could purchase lower cost insurance through the Marketplace. His Marketplace plan went into effect beginning May Emily had employer-sponsored coverage in January Emily maintained coverage through her employer all year. In this example, the tax household consists of Warren and Emily. Each has 12 months of qualified coverage, but Warren has four months of direct purchase and eight months of Marketplace coverage, while Emily has 12 months of employer-sponsored coverage.m State and Federal Marketplaces Individuals without health insurance coverage or those looking for more affordable coverage may purchase coverage through a state Marketplace or the federal Marketplace < if their state does not operate its own Marketplace. H&R Block offers enrollment services through its portal <healthcare.hrblock.com>. Coverage may be purchased during the annual open enrollment period. For coverage in calendar year 2015, the open enrollment period ran from November 15, 2014, through February 15, 2015, to submit an initial application, plus an extension to April 15 to complete the application, if necessary. For coverage in calendar year 2016, the open enrollment period was November 15, 2015, through January 31, Individuals may also purchase coverage outside the open enrollment period during special enrollment periods, generally 60 days, following certain life events where there was a change in: Family status (marriage, divorce). Location. Citizenship/residency status. Family size or household income that affects eligibility for the APTC. Loss of other types of qualifying coverage, such as employer-sponsored coverage. An insurance plan that is certified by the Marketplace provides minimum essential coverage and follows established limits on cost-sharing (like deductibles, copayments, and out-of-pocket maximum amounts). A qualified health plan will have a certification by each Marketplace in which it is offered.

17 Credits Plans in the Marketplace are categorized into four types Bronze, Silver, Gold, or Platinum based on the percentage the plan pays of the average overall cost of providing coverage to members. The percentages the plans will spend, on average, are 60% (Bronze), 70% (Silver), 80% (Gold), and 90% (Platinum). Form 1095-A Taxpayers who had coverage through the Marketplace will be sent a Form 1095-A, Health Insurance Marketplace Statement, regardless of whether they were eligible for the APTC or elected to receive it. The 2015 forms must be issued by January 31, All taxpayers who obtained coverage through the Marketplace for themselves, a spouse, or dependents and received either the APTC, or are eligible to claim the PTC on their tax return, must have a Form 1095-A to complete their tax return. Tax Tip: Some divorced taxpayers may experience a situation where tax benefits for dependents are divided between the parents, and one parent enrolls the child in a Marketplace plan, but the other parent claims the child s dependency exemption. This situation requires an allocation of information on Form 1095-A between the two parents. Form 1095-A is divided into the following three parts: Part 1, Recipient Information, reports identification information on the recipient and spouse. Part 2, Coverage Household, reports information on the individuals covered by the insurance policy and the dates of coverage. Part 3, Household Information, reports information required to reconcile the credit. The information is reported for every month of the year. Column A reports the total monthly premium for the plan without considering any amount that may be paid by the APTC. Column B reports the second lowest cost silver plan (SLCSP) as determined by the Marketplace. This is the benchmark against which the taxpayer s APTC is calculated. Column C reports the amount of APTC paid, if any. This information is used to complete Form 8962, Premium Tax Credit. Using the information from the example that begins on page 14.15, see Illustration 14.5 on page for Warren Bixby s Form 1095-A. Form 1095-B Form 1095-B, Health Coverage, is issued to taxpayers who are enrolled in the following types of healthcare coverage: Group coverage through eligible employer-sponsored plans. Group coverage through self-insured employer plans. Federal or state government agencies such as most Medicaid programs, Medicare Part A, CHIP, TRICARE, coverage administered by the Department of Veterans Affairs, coverage for Peace Corps volunteers, and Nonappropriated Fund Health Benefits Program of the Department of Defense.

18 14.18 H&R Block Income Tax Course (2016) Illustration X.X 14.5

19 Illustration 14.6 Credits 14.19

20 14.20 H&R Block Income Tax Course (2016) Illustration 14.7

21 Credits Miscellaneous types of plans, such as private health insurance plans, Medicare Part C, Refugee Medical Assistance, coverage provided to business owners who are not employees, and coverage under group health plans provided by a foreign government, if certain requirements are met. Illustration 14.6 on page shows Emily Bixby s Form 1095-B from the previous example. Form 1095-C Form 1095-C, Employer-Provided Health Insurance Offer and Coverage, is issued to taxpayers who are enrolled in the following type of health care coverage: Applicable large employers (ALEs) An ALE is an employer that employed on average at least 50 fulltime employees, including full-time equivalent employees (FTEs). A full-time employee is one who works on average at least 30 hours of service per week, or 130 hours of service per month. For purposes of determining whether an employer is an ALE, the FTE value of all employees who are not full-time is taken into account by adding their total monthly hours of service (maximum 120 hours per employee/month) and dividing by 120 hours to arrive at the number of FTE employees. Using Emily Bixby s information (from the previous example), but now assuming her employer is an ALE, Illustration 14.7 on page shows her Form 1095-C. Form 8962 Form 8962, Premium Tax Credit, calculates the taxpayer s PTC and reconciles it with any APTC received. Form 8962 must be filed for any taxpayer who received the APTC. Form 8962 may also be prepared for any taxpayer who is eligible for the PTC but did not receive the APTC. Information from Form 1095-A is used to complete Form Part 1 Part 1 of Form 8962 determines the amount the taxpayers are expected to contribute toward their own health care insurance premiums. Line 1. In line 1, family size means the taxpayer; their spouse, if filing a joint return; and the dependents, if any, claimed on the tax return. Compare that to tax household, as previously discussed, which means the taxpayer; their spouse, if filing a joint return; and all dependents, whether or not claimed by the taxpayer. Tax family is used to calculate the PTC, while tax household is used to determine if any ACA tax penalty is due. Lines 2a, 2b, and 3. Household income is the modified AGI of all individuals in the tax family who are required to file a tax return. Household income does not include the modified AGI for individuals in the tax family who file a tax return only to claim a refund of withholdings or estimated payments. Line 4. FPL for family size. As covered earlier, there are three charts. Line 5. Divide household income by FPL to get the family s household income as a percentage of FPL. Line 6. If the percentage of FPL is greater than 400%, the client is not eligible for the PTC. Line 7. Look up the applicable figure in the instructions by the FPL that is calculated in line 5.

22 14.22 H&R Block Income Tax Course (2016) Lines 8a and 8b. Multiply household income by the applicable figure to get the family s contribution amount for their health care insurance, and then divide that amount by 12 to get the amount of their monthly contribution. Part 2 Part 2 completes the calculation of the PTC and reconciles it with the amount of any APTC the taxpayer received. Part 3 Part 3 determines the amount, if any, of the APTC the taxpayer owes. For most taxpayers, the reconciliation process is simple. If the amount of APTC the taxpayer received exceeds the PTC calculated in Part 1, the taxpayer is required to pay back the excess, up to a limit for those with income less than 401% of the FPL, through the tax return. If the amount of APTC, if any, is less than the PTC calculated in Part 1, the taxpayer will receive that amount on their tax return in the form of a refundable credit. mexample: William is single and files as head of household. He is the sole provider for his son, Maxwell. William s APTC is equal to the PTC calculated in Part 1. William s Form 8962 showing the reconcilliation is shown in Illustration 14.8 on page m Tax Tip: A taxpayer s life circumstances can change any time during the year. A change in income can change an APTC with either an increase or decrease. It is important that they know they can contact the Marketplace when things change so that there are no surprises at tax time. Shared Policy Allocation For taxpayers who share a policy with individuals outside their tax family, the reconciliation process is more complicated and requires information from Form 1095-A to be allocated between the individuals. Allocation is required for taxpayers who purchased coverage through the Marketplace, when at least one of the following applies to their situation: A member of the tax family enrolled someone outside the tax family in qualified coverage. A member of the tax family was enrolled in qualified coverage by someone outside the tax family. The taxpayer got divorced or legally separated in The taxpayer is married at the end of the year but filing a separate return. One policy covers two or more tax families. Taxpayers who married during the year are also potentially eligible for an alternative calculation because they may have had both single and family plans in the same year.

23 Illustration 14.8 Credits 14.23

24 14.24 H&R Block Income Tax Course (2016) Illustration 14.9

25 Credits Note: The shared policy allocation is a complex tax topic. It is covered here at an awareness level. Only experienced Tax Professionals should prepare returns for taxpayers who qualify for it. See Illustration 14.9 on page for page 2 of Form 8962 where the allocation is computed. mexample: Jason and Vivienne were married at the beginning of They have three children together, and the family of five lived together at the beginning of the year. Jason and Vivienne enrolled in Marketplace coverage for themselves and their three children in December In April 2015, the couple separated and Vivienne and the youngest children moved out of the home. In September, the spouses became legally separated. Jason will file his tax return as head of household claiming the oldest child as his dependent, and Vivienne will also file as head of household, claiming the two younger children. Jason and Vivienne will need to complete a policy allocation because their Marketplace plan covered individuals in two tax families.m Groups Exempt from the Individual Mandate Membership in one of the following groups exempts taxpayers from the individual mandate: Health care sharing ministry. A health care sharing ministry is a 501(c)(3) organization continuously in existence since December 31, 1999, whose members share a common set of ethical or religious beliefs and share medical expenses in accordance with those beliefs and without regard to the state where the member lives or works. Federally recognized Indian tribes and individuals who are eligible for health services through the Indian Health Services. Certain religious sects that have objections to insurance, including medicare and social security. Nonresident aliens. Undocumented immigrants. How individual members of certain groups obtain their exemption from the individual mandate: Members of health care sharing ministries, federally recognized Indian tribes, and non-tribal members eligible for Indian Health Services: Members of certain religious sects: Nonresident aliens: Undocumented immigrants: Through the Marketplace or on Form 8965, which is filed with their tax return. Through the Marketplace. By filing Form 1040-NR. Form 8965, which is filed with their tax return. Note: Certain exemptions require the taxpayer to complete a form and mail it with any required documentation to the Marketplace. If approved, the client will receive an exemption certificate number that will need to be reported on Form 8965, Health Coverage Exemptions. T ax Tip: Tax Professionals should first look at claiming exemptions directly on the tax return as opposed to those available through the Marketplace because the tax return exemptions are claimed directly on Form 8965 and additional steps, such as submitting the Marketplace exemption application for approval by the Marketplace, are not required.

26 14.26 H&R Block Income Tax Course (2016) Exemptions Available Due to Various Circumstances The following circumstances make taxpayers eligible for exemptions from the individual mandate: Household income is below the filing status threshold. The software is programmed to recognize when a taxpayer is subject to the penalty but qualifies for this exemption. U.S. citizen or resident living outside the U.S. To qualify, the taxpayer must have spent 330 full days outside of the U.S. during a 12-month period or have been a resident of a foreign country or U.S. territory. Incarceration. Individuals qualify for this exemption for any month they are in a penal institution or correctional facility. The exemption is obtained by submitting an application to the Marketplace. Short coverage gap. Individuals qualify for this exemption if they did not have qualified coverage for less than three consecutive months. This exemption can only be claimed at the first occurrence and does not apply when the coverage gap is three or more months. Coverage by May 1. This exemption is available for individuals who had a coverage gap at the beginning of the year. Individuals qualify for this exemption if they purchased qualified health coverage that went into effect no later than May 1, Coverage is considered unaffordable. If the minimum premium amount (either through employer sponsored or Marketplace coverage) is more than 8% of household income, the coverage is considered unaffordable, and the individual qualifies for an exemption. CHIP coverage beginning after the start of the year. An exemption is available to individuals who applied for and obtained CHIP coverage during the open enrollment period, still leaving a gap at the beginning of the year. In addition to the circumstances listed on the previous page, exemptions are also granted when the taxpayer experienced any of the following hardships (this list is not all-inclusive): Canceled health policy. Lives in a state that did not expand Medicaid coverage. Domestic violence. Homelessness. Eviction in the past six months or facing eviction or foreclosure. Shut-off notice from a utility company. Fire, flood, or other natural or human-caused disaster that caused substantial damage to the taxpayer s property. Bankruptcy in the last six months. Medical expenses in the last 24 months that resulted in substantial debt. Unexpected increases in necessary expenses due to caring for an ill, disabled, or aging family member. Death of a close family member.

27 Credits BlockWorks Tip: BlockWorks has been programmed to determine if a taxpayer qualifies for the following ACA tax return exemptions based on information entered into the software. Some exemptions require more entries than others: Household Income Below the Return Filing Threshold Exemption. Gross Income Below the Return Filing Threshold Exemption. Coverage is Considered Unaffordable Exemption. Aggregate Self-Only Coverage Considered Unaffordable Exemption. Short Coverage Gap Exemption. This course gives you a good foundation of knowledge on the ACA examptions. Practice in the software and enrolling in upper-level courses will provide more information on how to prepare returns with ACA exemptions. mexample: Michael (25) and Michelle (23) are married. They have two children, Thomas (1) and Stephanie (2), who live with them all year and who do not provide more than half of their own support. Michael and Michelle file a joint return and have combined wages of $18,856. They have no other income. The couple is not required to file a tax return, but do so to claim the Earned Income Credit and Additional Child Tax Credit. Neither Michael nor Michelle had health insurance coverage in 2015, but both children had coverage through CHIP. Michael and Michelle are subject to the ACA penalty, but because their income is below their filing status threshold, they qualify for an exemption. The portion of their Form 8965 that reflects their exemption based on their circumstanes is in Illustration on page m The example above requires the following screens for Form 8965 in BlockWorks: Illustration 14.10

28 14.28 H&R Block Income Tax Course (2016) Illustration Illustration 14.12

29 Credits In this chapter, you learned: CHAPTER SUMMARY Credits are valuable to taxpayers because they reduce tax liability dollar for dollar. Nonrefundable credits may not reduce a taxpayer s tax liability below zero. Refundable credits may reduce the taxpayer s tax liability below zero, and the difference is refunded to the taxpayer. Taxpayers who pay someone else to care for their child or disabled dependent or spouse while they work or look for work may be eligible for the Child and Dependent Care Credit. The credit is computed on Form 2441 for taxpayers filing Form 1040 or Form 1040A. The amount of expenses eligible for the Child and Dependent Care Credit must be reduced by any employer-provided assistance that qualifies for exclusion from income. The premium tax credit (PTC) is a credit that helps pay the cost of coverage through the Marketplace. It is either advanced to the taxpayer, or refunded through their income tax return. It is important that you understand the basics of ACA compliance so that you can conduct a tax interview that correctly applies the premium tax credit. Suggested Reading For further information on the topics discussed in this chapter, you may wish to read the following sections of IRS Publication 17: Chapter 32, Child and Dependent Care Credit. Chapter 33, Credit for the Elderly or the Disabled. Chapter 37, Premium Tax Credit. You might also wish to read sections of IRS Publication 503, Child and Dependent Care Expenses. The Tax Institute at H&R Block Research Question: My client is a single parent who works full-time and pays daycare expenses for one of his two children. His four-year-old goes to a preschool that costs more than $6,000 a year. His ten-year-old attends an after-school care program free of charge at a community center. He can claim both as qualifying children on his tax return. The client does not have a pre-tax dependent care benefit available at work. Can he use $6,000 to compute the child care credit? Or, is he limited to $3,000 because he has paid expenses for only one of the children? A nswer: Your client may figure credit for child and dependent care expenses using the full $6,000. Under the regulations (Reg (a)(1)(ii)), the $6,000 applies if there are two or more qualifying individuals with respect to the taxpayer. Under Reg (b)(1)(i), a qualifying individual includes a taxpayer s dependent (who is a qualifying child) who has not attained age 13. Since your client has two qualifying children under the age of 13, he is considered to have two qualifying individuals, and the higher (i.e., $6,000) limit applies.

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31 15 1 BlockWorks Chapter Name Practice 3 OVERVIEW The BlockWorks Practice Session 3 is devoted to entering case studies into BlockWorks. This practice session will help you become familiar with the preparation of taxpayers income tax returns in the BlockWorks software and develop your tax interview skills at the tax desk. The case studies are set up as role-playing exercises to give you the experience of interviewing a client. This will help you start thinking of the kinds of questions you will ask to ensure a thorough tax interview, resulting in an accurate tax return. INSTRUCTIONS To complete the BlockWorks Practice Session 3, you will complete Case Studies 15.1 and 15.2 in the BlockWorks software. The case study return information can be found in your workbook starting on page W15.1. The case studies are set up in your workbook as interviews with taxpayers at the tax desk. To complete these case studies, you will need to partner with another participant in class. One individual will play the role of the Tax Professional and the other individual will play the role of the taxpayer. Each case study in your workbook is set as two scripts; the Tax Professional and the taxpayer. Use the script associated with your role to ask or answer questions and complete the case study return in the BlockWorks software. Lastly, you will spend the remainder of class enter prior ITC chapter case study returns in the BlockWorks software. Your instructor will provide you with guidance as to which chapter case studies you should enter into BlockWorks. 15.1

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33 16 Education Credits OVERVIEW Many clients, or their dependents, take education courses. Whether taxpayers are taking classes themselves or assisting children who are enrolled in education courses, there may be tax benefits available to clients with expenses for education. This chapter covers three common tax breaks for higher education: the American Opportunity Credit, the lifetime learning credit, and the tuition and fees deduction. OBJECTIVES At the conclusion of this chapter, you will be able to: Determine which expenses are eligible expenses for the American Opportunity Credit, the lifetime learning credit, and the tuition and fees deduction. Determine eligibility for the American Opportunity Credit and compute the credit. Determine eligibility for the lifetime learning credit and compute the credit. Determine eligibility for the tuition and fees deduction and compute the deduction. Compare/contrast the three benefits to obtain the maximum benefit for the taxpayer. TAX TERMS Look up the definitions of the following terms in the glossary: American Opportunity Credit (AOC). Credits. Lifetime learning credit. Nonrefundable credit. Refundable credit. Tuition and fees deduction. 16.1

34 16.2 H&R Block Income Tax Course (2016) CREDITS VS. DEDUCTIONS Recall from previous discussions that both credits and deductions help taxpayers reduce the amount of tax they must pay, although they do so in different ways. Deductions, such as the standard deduction, lower tax by reducing taxable income. Lower taxable income results in less tax. Unlike deductions, credits do not come into play until after taxable income has been computed and the tax determined. Then, credits may be used to directly reduce the tax. This chapter will focus on two credits and a deduction: The American Opportunity Credit is a credit that may be partly refundable. The lifetime learning credit is a nonrefundable credit. The tuition and fees deduction is taken as an adjustment to income, which means it may reduce taxable income. Tax Tip: Here is a helpful rule to think about the tax benefit hierarchy of education benefits: 1. Nontaxable benefits (for example, Pell Grants). 2. Refundable credits. 3. Nonrefundable credits. 4. Deductions. EDUCATION CREDITS For 2015, there are two education credits: the American Opportunity Credit (AOC) and the lifetime learning credit. This chapter will cover qualification and eligibility rules for both. There is another education credit, the Hope credit, that has not been available since It was replaced, at the time temporarily, by the AOC. We will not cover the details of the Hope credit, but it is important for Tax Professionals to know that it existed because taxpayers who want to claim the AOC must consider the years they claimed the Hope credit. American Opportunity Credit The AOC was created by the American Recovery and Reinvestment Act of 2009 (ARRA) and until recently, was scheduled to expire in The Protecting America from Tax Hikes PATH Act of 2015 made the AOC permanent. The AOC is a credit of up to $2,500 per eligible student, and up to 40% of the credit ($1,000) may be refundable. Let s take a closer look at the AOC.

35 Education Credits 16.3 Who Can Claim the AOC Generally, a taxpayer may claim the AOC if they meet all the following requirements: The taxpayer pays qualified education expenses for higher education. The qualified education expenses are paid for an eligible student. The eligible student is the taxpayer, spouse, or dependent for whom the taxpayer actually claims an exemption. Who Cannot Claim the AOC A taxpayer may not claim the AOC if any of the following are true: The taxpayer s filing status is MFS. The taxpayer is claimed as a dependent on anyone else s tax return. The taxpayer s modified adjusted gross income (MAGI) is above $90,000 ($180,000 for MFJ). For the AOC, MAGI equals AGI plus: Foreign earned income exclusion. Foreign housing exclusion. Foreign housing deduction. Income excluded by bona fide residents of American Samoa. Income excluded by bona fide residents of Puerto Rico. Note: The issues in the above list are advanced topics and are not covered in this course. If you have a client with any of these types of income, please consult an experienced Tax Professional in your office and/or IRS Publication 970, Tax Benefits for Education. The taxpayer (or spouse) was a nonresident alien for any part of 2015, and the nonresident alien did not elect to be treated as a resident alien for tax purposes. Note: Issues of resident vs. nonresident aliens are beyond the scope of this course. If you have a client with these issues, please consult an experienced Tax Professional in your office and/or IRS Publication 519, U.S. Tax Guide for Aliens. The taxpayer claims the lifetime learning credit or the tuition and fees deduction for the same student in Illustration 16.1 on page 16.4 is a very useful guide to who may claim the AOC for Dependents. A student who is claimed as a dependent on someone else s return may not claim an education credit for that tax year on their own return. Any qualified tuition and fees paid on behalf of a dependent student are treated as paid by the person who claims the dependency exemption. The expenses may be paid using the taxpayer s money, the student s money, loans, gifts, inheritances, and savings. mexample: Tracy Batt s dependent son, Donald (19), is a full-time student at Rowan University. All of Donald s tuition was paid with his own money and student loan proceeds. Nonetheless, Tracy may claim the AOC based on all of Donald s qualified expenses.m

36 16.4 H&R Block Income Tax Course (2016) Illustration 16.1

37 Education Credits 16.5 If a taxpayer is eligible to claim the student as a dependent but does not do so, only the student may claim the AOC for their qualifying expenses. mexample: Tracy Batt (from the preceding example) qualifies to claim Donald as a dependent, but her taxable income is already zero, so she chooses not to do so. Although Donald may not claim his own exemption, he may claim the AOC based upon all of his qualified expenses.m Qualified Education Expenses Qualified expenses for the AOC are tuition and certain related expenses required for enrollment or attendance at an eligible educational institution. Eligible educational institution. An eligible educational institution is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the U.S. Department of Education (USDOE). This includes virtually all accredited public, nonprofit, and proprietary (privately-owned, profit-making) postsecondary institutions. It also includes certain educational institutions located outside the United States that are eligible to participate in a student aid program administered by the U.S. Department of Education. Certain related expenses. For purposes of the AOC, expenses for books, supplies, and equipment needed for a course of study are qualified education expenses, whether or not the materials are purchased from the educational institution. Expenses involving student activities, sports, games, or hobbies are qualified expenses only if they are required by the institution as part of a degree program. Nonqualified expenses. Expenses for meals, room and board, athletic fees, insurance, transportation, and other personal living expenses are not qualified education expenses for the AOC. mexample: Terri Dougherty is a degree candidate at State University. In addition to her tuition and required course fees, she purchased her textbooks from an online bookstore not affiliated with the university. For the AOC, the tuition and course fees and the expense for Terri s books are qualified expenses.m mexample: Jefferson is a sophomore in Local State University s degree program in dentistry. In 2015, in addition to tuition, Jefferson is required to pay a rental fee to the university for dental equipment he will use in the program. Because the equipment rental is needed for his course of study, the rental fee is a qualified education expense for the AOC.m mexample: In 2015, Krissy enrolled at Private College for her freshman year. In addition to her tuition, Krissy had to pay a separate student activity fee. The fee is required of all students, and is used solely to fund the student government; none of the fee covers personal expenses for any student. Although the fee is labeled as a student activity fee, the fee is required for Krissy s attendance at Private College, and is a qualified expense for the AOC.m Reduction of qualified educational expenses. Qualified educational expenses paid with tax-free funds may not be used to claim the AOC. Qualified expenses must be reduced by any nontaxable benefits (including but not limited to): Scholarships. Grants. Veteran s or military educational benefits.

38 16.6 H&R Block Income Tax Course (2016) Tax Tip: Tax-free funds specifically designated to pay expenses other than qualified expenses (such as a scholarship specifically designated to pay room and board) do not reduce qualified educational expenses. Qualified expenses must also be reduced by excludible amounts withdrawn from the student s Coverdell Education Savings Account (Coverdell ESA) or qualified tuition plan (QTP). For information on Coverdell ESAs and QTPs, see IRS Publication 970, Tax Benefits for Education. Tax Tip: If you have a client who has taken distributions from an ESA or a QTP plan, please partner with an experienced Tax Professional in your office and refer to IRS Publication 970, Tax Benefits for Education. Qualifying Academic Periods The AOC is available for the year in which the qualified expenses are paid. The qualifying education must begin during that year or within three months following that year. For example, amounts paid in 2015 for an academic period that begins before April , are eligible expenses for An academic period begins on the first day of classes. Student loans. If the proceeds of a loan are used to pay expenses, the education credit is based on the amount of the expenses paid (rather than the amount of the loan payments) and are considered paid in the year the institution was paid, not in the year the loan was repaid. When the loan proceeds are disbursed directly to the institution, the expenses are considered paid when the student s account is credited. If the actual date is unknown, the expenses are considered paid on the last day the institution would have accepted the payment for that academic period. Third-party payments. In cases where a third party makes a payment directly to the educational institution to pay for a student s qualified expenses, the student is treated as having paid the expenses. Expenses refunded. If qualified expenses are refunded by the institution (for example, because the student withdraws from a class) before the filing of the return for that tax year, the credit is based on the amount paid after subtracting the refund. However, if the student files their return claiming a credit for the full amount and later receives a refund, they will have to recapture (pay back) some of the credit claimed. The recapture is beyond the scope of this course. If you have a client with this issue, please consult an experienced Tax Professional in your office and/or refer to IRS Publication 970. mexample: In December 2015, Tiffany Knight paid $2,000 in qualified expenses for the spring 2015 semester. Early in 2015, before filing her 2015 tax return, she withdrew from a foreign language class and received a tuition refund of $400. Her 2015 AOC will be based on $1,600 of qualified expenses.m

39 Eligible Student Education Credits 16.7 For 2015, an eligible student for the AOC is a student who meets all of the following conditions: The student has not claimed an AOC in any four earlier tax years (this includes any tax years in which the Hope credit was claimed for the student). The student did not complete the first four years (generally, the freshman, sophomore, junior, and senior years) of postsecondary education before Note: Academic credit awarded solely on the basis of performance on proficiency exams is not taken into account when determining whether the student has completed the four years of postsecondary education. The student was enrolled at least half-time in a program leading to a degree, certificate, or other recognized academic credential for at least one academic period beginning in Note: The standard for at least half-time is determined by each eligible educational institution. If the student is not certain if they were at least a half-time student, the institution can tell them. The student had not been convicted of any federal or state felony for possessing or distributing a controlled substance as of the end of These requirements are outlined in Illustration 16.2 on page Complete Exercises 16.1, 16.2, and 16.3 before continuing to read. Calculating and Claiming the AOC The AOC is available up to $2,500 per eligible student on the tax return. The amount of the AOC is the sum of: % of the first $2,000 of qualified education expenses paid for the eligible student % of the next $2,000 of qualified education expenses paid for the eligible student. The maximum AOC which may be claimed for 2015 is $2,500 times the number of eligible students on the tax return. Up to 40% of the AOC may be a refundable credit. Income Limitation As previously covered, certain levels of MAGI reduce or eliminate the AOC. We covered the definition of MAGI on pages 16.2 and Now, let s take a look at its effect on the AOC. The AOC is phased out for taxpayers with MAGI between $80,000 and $90,000 ($160,000 and $180,000 MFJ). The AOC is not available to taxpayers with MAGI above $90,000 ($180,000 MFJ).

40 16.8 H&R Block Income Tax Course (2016) Illustration 16.2

41 Education Credits 16.9 The credit for taxpayers filing a joint return is computed by multiplying the tentative credit by: $180,000 Modified AGI $20,000 For all other filing statuses, multiply the tentative credit by: $90,000 Modified AGI $10,000 mexample: Jack and Jill are married and will file a joint 2015 tax return. They have a tentative AOC of $2,500 and MAGI of $165,000. Their AOC is reduced to $1,875: $2,500 2 $180,000 $165,000 = $1,875 m $20,000 Form 1098-T Generally, an eligible educational institution must send each enrolled student Form 1098-T (or an acceptable substitute) each year. Form 1098-T contains the information needed to help claim the AOC. Refer to Form 1098-T in Illustration 16.3 on page Following is a brief explanation of each entry on Form 1098-T: Box 1 shows the total amount of payments received by the institution for the student s qualified expenses. This amount has been reduced by reimbursements or refunds, if any. Box 2 indicates the net amount of tuition and qualified expenses billed to the student. Tax Tip: The amounts in boxes 1 and 2 of Form 1098-T may differ from the amount the client actually paid. Be sure to use the amount paid or deemed paid in 2015 to calculate the AOC. The institution may choose to report either payments actually received (box 1) or amounts billed (box 2) during the year for qualified education expenses. Box 3 will be checked if the educational institution has changed their method of reporting. Box 4 contains any adjustments made for a prior year s qualified expenses previously reported on Form 1098-T. If there is an entry in this box, the taxpayer may need to recapture a prior year s education credit. See IRS Publication 970 if you encounter this situation. Box 5 shows the total of all scholarships or grants received by the institution on behalf of the student. As mentioned earlier, these amounts will reduce the amount of qualified expenses in box 1 for purposes of the education credit. Box 6 contains adjustments to scholarships or grants for a prior year. As with box 4, if there is an entry in this box, the taxpayer may be looking at some credit recapture. Box 7 will be checked if the amount in box 1 or 2 includes amounts for an academic period beginning after December 31, 2015, and before April 1, Because these amounts are eligible for a 2015 education credit, this check box does not change any of the entries on the 2015 tax return.

42 16.10 H&R Block Income Tax Course (2016) Box 8 will be checked if the student is considered to be carrying at least one-half the normal full-time work load for their course of study at the institution. As you know, the student must be at least a halftime student for at least one academic period during the year to qualify for the AOC. Box 9 will be checked if the student is enrolled in a graduate program. Such a student is probably not eligible for the AOC. If the student is still in the first four years of postsecondary education, they can receive the AOC. Box 10 shows the total amount of reimbursements or refunds of qualified expenses made by an insurer. As with box 4, these amounts will reduce the amount of qualified expenses for purposes of the education credit. Illustration 16.3 Claiming the AOC The AOC is claimed on Form 8863 (refer to Illustrations 16.4 through 16.6 on pages ). We re going to walk through Form 8863 using this example: mexample: Mary Williams ( ) is single and cannot be claimed as a dependent by any other taxpayer. In 2015, Mary enrolled full-time at a local college (the college is a qualifying educational institution) to earn a degree in law enforcement. The first year of Mary s postsecondary education was Mary received Form 1098-T from the college. Mary s expenses meet all of the qualifications for the AOC. In addition to the expenses reported on Form 1098-T, Mary spent $712 for needed textbooks, which she purchased through an online book retailer. Mary s 2015 AGI (and MAGI) is $39,000. Mary s Form 1098-T is shown in Illustration 16.3, above. Mary s AOC is claimed on Form 8863 (see Illustrations 16.4, 16.5, and 16.6). Mary had no other credits on her tax return. Note: Mary s total qualified education expenses are $6,312. Subtracting out the $1,000 grant leaves expenses of $5,312. However, only $4,000 is entered in Form 8863, Part III, line 28. This is because $4,000 is the maximum amount of qualified education expenses upon which the AOC is based.m

43 Nonrefundable AOC Education Credits As previously covered, up to 40% of the AOC may be available to the taxpayer as a refundable credit. However, it is extremely important to note that the refundable part of the AOC is not available to all taxpayers. A taxpayer does not qualify for the refundable credit if he or she is any of the following: Under age 18 at the end of Age 18 at the end of 2015 and earned income was less than one-half of the taxpayer s support. A full-time student over age 18 and under age 24 at the end of 2015 and earned income was less than one-half of the taxpayer s support. And: Has at least one parent who was alive at the end of Is not filing a joint return for Complete Exercise 16.4 before continuing to read. LIFETIME LEARNING CREDIT The amount of the lifetime learning credit is 20% of the total qualified expenses for all eligible students on the tax return. The maximum amount of expenses allowed per tax return is $10,000; therefore, the maximum annual credit is $2,000 per return, regardless of the number of eligible students. This is significantly different than the AOC maximum of $2,500 per student. However, the lifetime learning credit may be claimed for an unlimited number of tax years. Qualified Expenses Qualified expenses for the lifetime learning credit include expenses incurred by a student for either of the following reasons: The student is enrolled in a course that is part of a degree program for undergraduate or graduate-level courses. The student took courses to acquire or improve job skills. There is no requirement that the student attend school on at least a half-time basis. For example, a Tax Professional may claim the lifetime learning credit for a tax course provided by an eligible educational institution (as defined earlier), even if this is the only class they take. They need not be enrolled on a half-time basis or in a degree program. For purposes of the lifetime learning credit, qualifying expenses generally do not include books. This is a significant difference from the AOC we covered earlier. The lifetime learning credit phases out for taxpayers with MAGI between $55,000 65,000 ($110, ,000 MFJ).

44 16.12 H&R Block Income Tax Course (2016) Illustration 16.4

45 Illustration 16.5 Education Credits 16.13

46 16.14 H&R Block Income Tax Course (2016) Illustration 16.6

47 Illustration 16.7 Education Credits 16.15

48 16.16 H&R Block Income Tax Course (2016) mexample 1: John and Lisa Proctor have modified AGI of $75,000. Their dependent son, Joseph, is a college freshman at the beginning of the tax year. Joseph does not attend school on at least a half-time basis. The Proctors paid qualified education expenses totaling $6,000. The lifetime learning credit for 2015 is $1,200 [$6, % = $1,200].m mexample 2: The facts are the same as in Example 1, except the qualified expenses are $12,000. In this case, the lifetime learning credit would be $2,000 [$10, % = $2,000].m The lifetime learning credit and the AOC may not be claimed for the same student for the same year, but each credit may be claimed for different students for the same year. The flowchart in Illustration 16.7 is an excellent reference to help determine who may claim the lifetime learning credit for Claiming the Lifetime Learning Credit The lifetime learning credit is claimed on Form 8863, Part III. As with the AOC, the calculation is pretty straightforward. Let s assume Mary Williams (from the example on page 16.10) is in her fifth year of college in In this case, Mary will not qualify for the AOC (she has completed her first four years of postsecondary education), but she will qualify for the lifetime learning credit. Mary s completed Form 8863 is presented in Illustrations 16.8, 16.9, and on pages through TUITION AND FEES DEDUCTION Congress has extended the tuition and fees deduction through Taxpayers may deduct up to $4,000 as an adjustment to income for qualified tuition and related expenses. The deduction is a per-return limit, not a per-student limit. The deduction is figured on Form 8917, Tuition and Fees Deduction, and claimed on Form 1040A, line 19. See Illustration on page Who Is an Eligible Student? An eligible student is any student who is enrolled in any postsecondary educational institution which is eligible to participate in a student aid program administered by the Department of Education. This would include almost all accredited public, nonprofit, and proprietary (privately-owned, profit-making) postsecondary institutions. Who May Claim the Deduction? In order to claim the deduction, the taxpayer must have paid the qualified expenses for themselves, a spouse, or a dependent who is claimed as an exemption by the taxpayer. If the taxpayer did not pay the expenses, they cannot claim the deduction. If the dependent paid the expenses and the taxpayer claims the dependency exemption, no one claims the deduction. The chart in Illustration 16.11, on page 16.20, is a helpful guide to determine who may claim the deduction in the case of a dependent student.

49 Illustration 16.8 Education Credits 16.17

50 16.18 H&R Block Income Tax Course (2016) Illustration 16.9

51 Illustration Education Credits 16.19

52 16.20 H&R Block Income Tax Course (2016) Illustration TUITION AND FEES DEDUCTION Who Can Claim a Dependent s Expenses?

53 Phaseout of Tuition and Fees Deduction Education Credits The tuition and fees deduction phases out for taxpayers with MAGI between $65,000 ($130,000 MFJ) and $80,000 ($160,000 MFJ). Unlike some tax benefits, which phase out at a more or less constant rate, the tuition and fees deduction phases out in steps, as shown below in Illustration mexample: Let s assume Mary Williams (from previous examples) has an AGI of $70,000 and is in her fifth year of college. In this case, Mary does not qualify for the AOC, because she is in her fifth year, and she will not qualify for the lifetime learning credit because her income is too high. Mary qualifies for the tuition and fees deduction. The first page of her 1040A and her completed Form 8917 is presented in Illustrations and on pages and m Illustration 16.12

54 16.22 H&R Block Income Tax Course (2016) Illustration 16.13

55 Illustration Education Credits 16.23

56 16.24 H&R Block Income Tax Course (2016) Qualified Expenses Qualified expenses for the tuition and fees deduction are tuition and certain related expenses required for enrollment or attendance at an eligible educational institution. Related expenses may include student-activity fees and expenses for course-related books, supplies, and equipment. These are eligible expenses only if they must be paid to the institution as a condition of enrollment or attendance. Room and board are not qualified expenses. mexample: Blake is a sophomore in University K s degree program in microbiology. This year, in addition to tuition, he is required to pay a fee to the university for the rental of the lab equipment he will use in the program. Because the equipment rental fee must be paid to the university, it is a qualified expense.m mexample: Stacy attends College J. Her tuition and fees for the year were $3,458. She also purchased books at the off-campus Wildcat Bookstore, costing $257, for her classes. Her qualified expenses for the tuition and fees deduction would be $3,458, because this expense was not paid to the institution.m Remember: Expenses used for education credits are not necessarily qualified expenses for the tuition and fees deduction. Also, any student who uses an education credit cannot use the tuition and fees deduction, even for expenses above those used for the credit. Complete Exercise 16.5 before continuing to read. In this chapter, you learned: CHAPTER SUMMARY Which educational expenses are eligible expenses for the tuition and fees deduction, the American Opportunity Credit (AOC), and the lifetime learning credit. The tuition and fees deduction of up to $4,000 is available for degree candidates and students taking college courses to maintain or improve their current job skills. The deduction is figured on Form 8917 and entered on Form 1040A, line 19. Taxpayers who pay for higher education may qualify for one or more education tax breaks. The AOC is available for degree candidates who have not completed their first four years of postsecondary education as of the beginning of the tax year. The lifetime learning credit is available for all years of higher education for degree candidates and students taking college courses to maintain or improve their current job skills. Suggested Reading For further information on the topics discussed in this chapter, you may wish to read the following sections of IRS Publication 17: Chapter 19, Education-Related Adjustments. IRS Publication 970, Tax Benefits for Education, is also an invaluable resource for this topic.

57 Education Credits The Tax Institute Tax in the News Research Question: Our clients have contributed about $5,000 to a Coverdell ESA for their son. They opened the account when he was a child (when they were still called Education IRAs!) and have contributed intermittently since then. Unfortunately, their son, who will soon turn 18, told them he has no intention of continuing his education after high school. What happens to the money at this point? Can the funds be rolled over to another kind of savings account for him, such as a Roth IRA? Answer: Your clients may not roll over the unused ESA funds into any type of IRA, either for themselves or for their son. There are three possibilities for the ESA, rather than closing the account and distributing all of the funds. First, your clients should keep in mind that the ESA can remain intact until their son turns 30. Although he may be adamant about not going to college right now, he could change his mind in a few years. Also, education expenses for ESAs include tuition and other costs for qualifying vocational schools, which may be a type of education that interests their son. Second, the ESA can be rolled over tax-free to an ESA for another family member who is related to their son in one of several ways, including his siblings and first cousins. Finally, as a point of information, the ESA can be rolled over tax-free to a qualified tuition program (QTP) for their son. Obviously, for this family, a QTP rollover may not be a good choice. If your clients decide to close the account and distribute all of the funds, the earnings portion of the distribution will be taxable to their son. The distribution will be reported on Form 1099-Q, Payments from Qualified Education Programs. For more information, including a list of acceptable relatives for rollover purposes, see Coverdell Education Savings Account (ESA) in IRS Pub. 970, Tax Benefits for Education, and instructions to Form 1099-Q. Note that we assume your client s son is not a special needs beneficiary. If he were, the age limitation does not apply and the funds could remain in the ESA indefinitely.

58

59 17 Retirement OVERVIEW You have probably read or heard news stories stating that Americans are not saving nearly enough for retirement. The IRS Tax Code seeks to encourage retirement savings by making a variety of tax breaks available to taxpayers when they save for retirement. This chapter will cover some of the more common retirement savings plans available to individual taxpayers. In retirement planning, generally there are two parts. The first part of retirement is building your retirement accounts, so that when you retire the second part you can strategically withdraw the funds to live out your retirement. This chapter covers a brief overview of both contributing to and taking distributions from retirement plans. OBJECTIVES At the conclusion of this chapter, you will be able to: Explain the features of commonly available retirement accounts and the tax benefits of contributing to these accounts. Determine if a taxpayer is eligible to contribute to a traditional or Roth IRA, and determine the deductible amount of traditional IRA contributions. Determine a taxpayer s eligibility for the retirement savings contribution credit and calculate the amount of the credit. Determine and accurately report the taxable portion of social security or tier 1 railroad retirement benefits. Identify and accurately report taxable qualified retirement plan and IRA distributions. Explain the consequences of an early retirement plan and IRA distributions. 17.1

60 17.2 H&R Block Income Tax Course (2016) TAX TERMS Look up the definitions of the following terms in the glossary: 401(k) plan. 403(b) plan. 457 plan. Annuity. Contribution. Defined benefit plan. Defined contribution plan. Distribution. Pension. Rollover. Roth IRA. Traditional IRA. TYPES OF RETIREMENT PLANS While there are a wide variety of retirement plans, for our purpose, we are going to focus on qualified plans and nonqualified plans. Qualified Plans A qualified plan is a plan that is eligible for favorable tax treatment because it meets the requirements of both the following: IRC 401(a). The Employment Retirement Income Security Act of 1974 (ERISA). A qualified plan is allowed some very advantageous tax treatment: Employers may deduct the annual allowable contributions that they make for each plan participant. Contributions and earnings on those contributions are tax-deferred until withdrawn for each participant. In some cases, taxes may be deferred even further through a transfer into a different type of IRA account (we will cover IRA accounts later in this chapter).

61 Retirement 17.3 Nonqualified Plans As you probably suspect, a nonqualified plan is basically the opposite of a qualified plan. Nonqualified plans do not meet the requirements of IRC 401(a) and ERISA, and do not qualify for favorable tax treatment. Nonqualified plans are: Usually designed to meet specialized retirement needs of key executives and other select employees. Exempt from the discriminatory and top-heavy testing to which qualified plans are subject. Contributions to a nonqualified plan are usually nondeductible to the employer. Nonqualified plans do allow employees to defer taxes until retirement; at retirement, distributions from a nonqualified plan are usually made in the form of an annuity. Note: You do need to know the basic features of qualified vs. nonqualified plans, but do not get too wound up in it. We are going to concentrate on contributions to and distributions from qualified plans or plans that are basically treated as qualified plans. QUALIFIED PLANS There are two kinds of qualified plans, defined benefit and defined contribution plans. A defined benefit plan is a retirement plan where the employee receives a predetermined formula-based benefit at retirement. The most common known type of defined benefit plan is a pension, in which the retirement benefit is calculated by a formula based on number of years worked, age, and the taxpayer s history of earnings with the employer. Another type of defined benefit plan is an annuity. An annuity is a series of payments under a contract, made at regular intervals over a period of more than one year. The taxpayer can buy the annuity contract alone or with the help of their employer. Annuities are often purchased from life insurance companies. For these types of retirement accounts, generally the employer and/or employee makes payments to fund the pension or annuity. A defined contribution plan (also called a deferred compensation plan) is a retirement plan where the employee and/or employer make pre-tax contributions into a retirement account where the contributions and earnings grow tax-free until the money is withdrawn. The most commonly known type of deferred compensation plan is a 401(k). The following are common types of deferred compensation plans that you may encounter at the tax desk.

62 17.4 H&R Block Income Tax Course (2016) 401(k) Plans A widely available and popular type of qualified deferred compensation plan is the 401(k) plan. 401(k) plans take their name from IRC 401(k), which governs their existence. As a qualified plan, 401(k)s offer significant tax advantages: Employee contributions to the plan are tax-deferred. This means the employee does not pay federal income tax on the amount of the contributions in the year contributed. Most states also allow contributions to be tax-deferred, although some contributions may be subject to local income tax. Tax is not paid until the taxpayer receives a distribution, or, in other words, withdrawal, from the plan. Earnings on the contributions are also tax-deferred until the taxpayer receives a distribution from the plan. Employer-Matching Contributions The 401(k) plans may also have another potential benefit. The employer may opt to match all or part of the employee s contributions to the account. This may be done by: Making an additional contribution to the account on behalf of the employee. Offering a profit-sharing contribution to the plan. mexample: Ted s employer offers their employees a 401(k) plan. The employer offers a matching contribution for each percent the employee contributes, up to 5%, of their annual salary to the plan. If Ted contributes 10% of his annual salary to the plan, his employer will make matching contributions equal to 5%. This means Ted is saving 15% of his annual salary for an out-of-pocket expenditure of only 10%.m Tax Tip: Taking advantage of any employer-matching contribution is a fantastic way to help build retirement savings. Depending on the taxpayer s available cash flow, it is always advantageous for the taxpayers to make the minimum contribution to the retirement plan to receive the employer s maximum matching contribution, because the employer s matching contribution is free money. 403(b) Plans A 403(b) plan is a tax-advantaged retirement savings plan available for employees of the following types of organizations: Public education. Some nonprofit. Cooperative hospital service. Employee contributions to a 403(b) plan are tax-deferred, and so are earnings on the plan.

63 Retirement 17.5 Note: Technically, 403(b) plans are not qualified plans. However, their main features are identical to those of qualified plans. For our purpose, we are going to treat 403(b) plans the same as a qualified plan. 457 Plans 457 plans are tax-advantaged, deferred-compensation retirement plans available primarily to governmental employees. These 457 plans are not qualified plans, but their primary features are identical to qualified plans. Contributions to the plan, and earnings on those contributions, are tax-deferred until the employee receives distributions from the plan. Contribution Limits As wonderful a deal as a deferred-compensation plan is, employees are not allowed to contribute an unlimited amount to their plan. The IRS does set annual maximum limits on the amount that can be contributed. These amounts are indexed for inflation and generally rise each year (much as the allowable amount for the standard deduction generally rises each year). Taxpayers who exceed retirement contribution limits may be subject penalties if the excess amount is not withdrawn by April 15th of the following tax year. For 2015, the maximum annual allowable contribution is $18,000. Taxpayers over the age of 50 are allowed an annual catch up contribution of $6,000. Note: As mentioned, allowable contributions to plans are generally set as a percentage of an employee s salary. Therefore, the maximum amount any one taxpayer can contribute is a function of both the maximum annual limit and the allowable percentage of salary that may be contributed. mexample: John Conners annual salary is $100,000. His employer sponsors a 401(k) plan, which allows each employee to contribute a percentage of their annual salary up to the IRS annual contribution limit. John chooses to contribute the amount of 5% of his annual salary. Therefore, for 2015, John s 401(k) contribution is $5,000 [$100, % = $5,000].m Identifying Contributions to a Deferred-Compensation Plan In order to accurately and completely prepare a tax return, it is essential to know how much the taxpayer contributed to a deferred-compensation plan. Fortunately, the taxpayer s Form W-2 generally contains all the information you need. Recall from Chapter 2 that there are a variety of codes that can be entered on Form W-2 to communicate a great deal of information. We are interested in box 12 and the codes that identify deferred-compensation plans. Refer to Illustrations 17.1 and 17.2 on the following page. mexample: Illustration 17.1 shows John Conners Form W-2 (from our earlier example). Notice the difference between the amount in box 1 and the amounts in boxes 3 and 5. The $5,000 difference is the amount John contributed on a tax-deferred basis to his 401(k) plan. The $5, (k) contribution is reported in box 12 with the code D.m Complete Exercise 17.1 before continuing to read.

64 17.6 H&R Block Income Tax Course (2016) Illustration 17.1 Illustration 17.2

65 Retirement 17.7 IRAS An individual retirement arrangement (IRA) is a personal savings plan that gives taxpayers tax advantages for saving money for retirement. Two tax advantages of an IRA are that: Money contributed to the IRA may be fully or partially deductible. Amounts in the IRA grow tax-free and are not taxed until the money is withdrawn from the IRA account. Generally, a qualifying taxpayer has the option to fund two types of IRA accounts, a traditional IRA and a Roth IRA. Details about both types of IRAs will be discussed later. Compensation To qualify to contribute to an IRA, a taxpayer must have earned income, or compensation. For IRA purposes, compensation includes wages, salaries, tips, commissions, professional fees, bonuses, net self-employment income, and other amounts the taxpayer receives for providing personal services, as well as alimony payments. If the taxpayer s Form W-2 shows any nonqualified plan distribution or 457 plan distribution in box 11, that amount must be subtracted from the taxpayer s wages when determining their compensation for IRA purposes. Investment income, foreign earned income, or business income where the taxpayer does not actively participate does not qualify as compensation for IRA contributions. Any foreign earned income, housing exclusion, or deduction the taxpayer is claiming must be subtracted to arrive at total compensation. For 2015, the maximum allowable contribution to an IRA (traditional or Roth) is the lesser of the following: $5,500 ($6,500 if the taxpayer has reached age 50 by the end of the tax year). 100% of the taxpayer s compensation. For this purpose, a taxpayer is considered to have reached age 50 on the day before their birthday. Thus, a taxpayer born January 1, 1965, is considered to have reached age 50 at the end of Please note that the total of all traditional and Roth IRA contributions combined for the year cannot exceed $5,500 ($6,500 if age 50 or older). So a taxpayer could contribute $5,500 to their traditional IRA or $5,500 to the Roth IRA, but not $5,500 to both their traditional and Roth IRAs because their combined IRA contribution would equal $11,000. If the taxpayer wishes to contribute to both their traditional and Roth IRA, they would have to split the $5,500 maximum contribution limit between both accounts. For example, a taxpayer could contribute $2,500 to their traditional IRA and $3,000 to their Roth IRA.

66 17.8 H&R Block Income Tax Course (2016) TRADITIONAL IRAS In order to establish and contribute to a traditional IRA, a taxpayer must have taxable compensation and must not have reached age 70½ by the end of the tax year. For this purpose, a taxpayer is considered to have reached age 70½ six months after their 70th birthday. Contributions to traditional IRAs may be deductible from gross income, as an adjustment to income on Form 1040A, line 17, if the taxpayer qualifies for the deduction. The advantage of a traditional IRA is that the taxpayer can often deduct amounts set aside for retirement and then watch the fund grow tax-free while in the IRA account. When the taxpayer reaches age 59½, they can withdraw the funds from the IRA without a penalty. However, the money is generally taxable at that time. The taxpayer is often in a lower tax bracket due to retirement, and will pay less income tax. Money placed in an IRA should be considered a long-term investment because amounts withdrawn before the taxpayer reaches age 59½ are usually subject to a 10% early withdrawal penalty. Different Sets of Rules There are separate sets of rules concerning the deductibility of traditional IRA contributions for each of three different types of taxpayers: Taxpayers who are active participants in employer-maintained retirement plans at any time during the year. Taxpayers who are not active participants, including joint filers whose spouses are not active participants. Joint filers who are not active participants, but whose spouses are active participants. Who Is an Active Participant? A taxpayer is an active participant in an employer-maintained retirement plan if they participate at any time during the year in any of the following: A qualified retirement, profit-sharing, or stock bonus plan (for example, a 401(k) plan). A qualified annuity plan. A 403(b) tax-sheltered annuity plan (available to employees of public schools and certain tax-exempt organizations). A SIMPLE plan. A government plan (other than a 457 plan). Certain pension plans funded solely by employee contributions. A plan established by a self-employed taxpayer (for example, a qualified plan or SEP). You do not need to become an expert in retirement plan terminology to know if an employee is covered by an employer-maintained plan. If box 13, the Retirement plan box, on the employee s Form W-2 is marked, the employee is an active participant. If the employee believes the box should not have been marked, they should obtain a corrected Form W-2 from their employer.

67 Retirement 17.9 An individual is not treated as an active participant solely because of their coverage under social security or railroad retirement (tier 1 or tier 2). A person who is receiving retirement benefits from a former employer s plan is not treated as an active participant unless they are covered under a current employer s plan. Taxpayers Who Are Not Active Participants IRA contributions made by taxpayers who are not active participants (and whose spouses are not active participants) are fully deductible up to the maximum allowable contribution amount. A taxpayer who uses the married filing separately status and who did not live with their spouse at any time during the year is treated as a single taxpayer for this purpose. If spouses both have compensation, each may establish an IRA, contribute, and deduct an amount within the limits. The allowable IRA contribution (and deduction) is computed separately without regard to any community property laws. An eligible married taxpayer may also establish a spousal IRA (an IRA for their spouse) even if the spouse has received little or no compensation for the tax year. A couple making contributions to a spousal IRA must file a joint return. mexample: Jim (48) and Sally (51) Spencer are filing jointly for Jim earned $35,000, and Sally earned $2,500. Jim may contribute up to $5,500 to his IRA for If Jim contributes the $5,500, Sally s compensation for IRA purposes is $32,000 [$35,000 + $2,500 $5,500 = $32,000]. The Spencers may contribute up to $6,500 to Sally s IRA for 2015.m An IRA may be established and contributed to until the due date (not including extensions) of the return for the year. That is, a contribution made to an IRA on or before April 15, 2016, may be designated for 2015, and a deduction is allowed on the 2015 return. Therefore, contributing to an IRA is one of the few actions a taxpayer can take to reduce tax liability after the tax year has ended. mexample: Lorna Mendiola (39), a single taxpayer who is not an active participant in an employer-maintained retirement plan, computed her taxable income to be $54,689 and her tax to be $9,463. Because she had only $9,369 withheld from her pay, she would owe the federal government $94. Lorna did not like the idea of paying additional income tax, so on April 14 she opened a traditional IRA at her bank and contributed $4,000. She changed her return to show a $4,000 IRA deduction. Now, her taxable income is reduced to $50,689, and her tax becomes $8,463. Thus, Lorna receives a refund of $906, and she saved $4,000 for her retirement.m Taxpayers Who Are Active Participants When considering taxpayers who are active participants in an employer-maintained retirement plan, we must be mindful of the distinction between contributing to an IRA and deducting that contribution. For active participants, the amount that may be contributed to a traditional IRA is the same as it is for nonparticipants. However, the amount that may be deducted is often limited. The limitation depends on the taxpayer s modified AGI.

68 17.10 H&R Block Income Tax Course (2016) Modified AGI (MAGI), for traditional IRA purposes, is determined by adding the following amounts to regular AGI (without regard to any IRA deductions): Student loan interest deduction from Form 1040A, line 18 (or Form 1040, line 33). Tuition and fees deduction from Form 1040A, line 19 (or Form 1040, line 34). Excludible employer-provided adoption benefits from Form 8839, line 20. Excludible U.S. Savings Bond interest from Form 8815, line 14. Domestic production activity deduction from Form 1040, line 35 (beyond the scope of this course). Certain excludible foreign and U.S. possession income (beyond the scope of this course). The chart in Illustration 17.3 below summarizes the phaseout ranges for Illustration TRADITIONAL IRA MODIFIED AGI PHASEOUT RANGES FOR ACTIVE PARTICIPANTS Filing Status Full Deduction Deduction Reduced No Deduction S, HH, MFS * $61,000 or less $61,001 70,999 $71,000 or more MFJ, QW $98,000 or less $98, ,999 $118+,000 or more MFS ** $1 9,999 $10,000 or more * Did not live with spouse at any time during the year ** Lived with spouse at some time during the year Nonparticipating Spouses A separate set of deduction limitations applies to married taxpayers who are not active participants in employer-maintained retirement plans, but who are filing joint returns with spouses who are active participants in such plans. These taxpayers are referred to as nonparticipating spouses. For 2015, a nonparticipating spouse is allowed a full deduction for a traditional IRA contribution if the couple s modified AGI is $183,000 or less. If their modified AGI is greater than $183,000 but less than $193,000, the maximum deduction allowed is reduced. If their modified AGI is $193,000 or higher, no deduction is allowed. BlockWorks provides a two-page worksheet, called the IRA Deduction Worksheet Line 32, to help Tax Professionals compute taxpayers total allowable contributions to their traditional IRAs and to determine how much of any traditional IRA contribution is deductible. The worksheet is shown in Illustrations 17.4 and 17.5.

69 Retirement mexample: Henri (39) and Michelle (39) Duval are married and filing a joint return on Form 1040A. Henri earned $69,700 and is an active participant in an employer-maintained retirement plan. Michelle earned $32,500 and is not an active participant. The Duvals total income is $102,200. Their only adjustment to income is a $151 student loan interest deduction, which makes their adjusted income $102,049. When determining MAGI for the traditional IRA deduction, the $151 student loan interest deduction is added back. This makes their MAGI equal to $102,200 [$102,049 + $151 = $102,200]. Henri and Michelle would like to contribute $5,500 each to their traditional IRAs for 2015, but they do not want to contribute more than they can deduct. Because Henri is an active participant in an employer-maintained retirement plan and the Duvals modified AGI is greater than $98,000, Henri s traditional IRA contribution deduction is limited to $4,350. However, Michelle is able to make the full $5,500 traditional IRA contribution because she is not an active participant in an employer-maintained retirement plan and the Duvals modified AGI is less than $183,000. The Duvals BlockWorks IRA Deduction Worksheet Line 32 is shown in Illustrations The Duvals are excited to be receiving a $9,850 IRA deduction on their Form 1040A, line 17.m ROTH IRAS Roth IRAs are an excellent way to save, not only for retirement, but beyond. Unlike traditional IRAs, taxpayers can make contributions to their Roth IRA after they reach age 70½. Since Roth IRAs do not have required distributions, the taxpayer could leave contributions in the account as long as they wish. Unless specific rules prescribe otherwise, the rules that apply to traditional IRAs also apply to Roth IRAs. For instance: To make contributions, the taxpayer must receive compensation during the year. Contributions must be made by the due date of the return, not including extensions. Contributions for each spouse are limited for 2015 to the lesser of $5,500 ($6,500 for those age 50 and older) or total compensation. Taxpayers can make contributions for themselves and a nonworking or lower-income spouse, if they file a joint return. Allowable Roth IRA contributions must be reduced by any amounts contributed to a traditional IRA, regardless of whether such contributions were deductible. Not Deductible. The main difference between a traditional IRA and a Roth IRA is that contributions to a Roth IRA are not deductible on Form 1040A. Qualified distributions, however, are exempt from tax. This means that the money earned inside the Roth IRA is usually tax-free. Because Roth IRA contributions are not deductible, these contributions are not reported on the tax return. However, it is important for the taxpayer to keep records of their Roth IRA contributions.

70 17.12 H&R Block Income Tax Course (2016) Illustration 17.4

71 Illustration 17.5 Retirement 17.13

72 17.14 H&R Block Income Tax Course (2016) The maximum allowable Roth IRA contribution is phased out based on the taxpayer s modified adjusted gross income. This phaseout range applies whether or not the taxpayer or spouse is an active participant. Participation in an employer-maintained retirement plan has no effect on Roth IRA contributions, and contributions can be made even after the taxpayer has reached age 70½. See Illustration 17.6 for a table of the 2015 Roth IRA modified AGI phaseout ranges based on the taxpayer s filing status. Illustration ROTH IRA MODIFIED AGI PHASEOUT RANGES Filing Status Full Contribution Contribution Reduced No Contribution S, HH, MFS * Less than $116,000 $116, ,999 $131,000 or more MFJ, QW Less than $183,000 $183, ,999 $193,000 or more MFS ** $0 $1 9,999 $10,000 or more * Did not live with spouse at any time during the year ** Lived with spouse at some time during the year For Roth IRA purposes, modified AGI is computed in the same manner that it is for traditional IRAs, except that income resulting from the conversion of a traditional IRA into a Roth IRA is not included. The BlockWorks 2015 Maximum Roth IRA Contribution Worksheet is used to compute the amount of Roth IRA contributions a taxpayer (and spouse) may make to their Roth IRA accounts. This worksheet is shown in Illustration For taxpayers whose traditional IRA deduction is reduced because they participate in an employer retirement plan and their modified AGI exceeds the threshold amount per filing status, the taxpayer may wish to contribute the exact amount of their traditional IRA contribution deduction to their traditional IRA and contribute the remaining portion to their Roth IRA, assuming their Roth IRA contribution is not limited due to their MAGI. mexample: Henri and Michelle Duval (from the preceding example) still wish to maximize Henri s 2015 IRA contribution limit, because the Duvals are very proactive about saving for their retirement. Because Henri s traditional IRA contribution deduction is limited to $4,350, he wants to contribute as much as he can to his Roth IRA. Because the Duvals modified AGI is below $183,000, Henri is allowed to contribute $1,150 to his Roth IRA account [$5,500 $4,350 = $1,150]. This way, he maximizes his $5,500 IRA contribution limit. Henri s BlockWorks 2015 Maximum Roth IRA Contribution Worksheet is shown in Illustration 17.7.m

73 Illustration 17.7 Retirement 17.15

74 17.16 H&R Block Income Tax Course (2016) Roth IRA Conversion. Taxpayers who have a traditional IRA have the ability to transfer all or part of the funds from their traditional IRA into a separate Roth IRA account. This transfer is called a Roth IRA conversion. The taxpayer is required to pay income tax on the transferred amounts in the year of conversion. The Roth IRA conversion is reported using Form 8606, Nondeductible IRAs. The traditional IRA funds may be transferred to the Roth IRA using the following methods: The taxpayer receives a distribution from their traditional IRA and personally contributes the money into their Roth IRA within 60 days of the distribution. This is called a rollover. The taxpayer requests the traditional IRA trustee to transfer the funds directly into their Roth IRA. This is called a trustee-to-trustee transfer. The taxpayer reclassifies their traditional IRA account as a Roth IRA, if the account is maintained by the same trustee. The taxpayer transfers all or part of their traditional IRA funds into a new Roth IRA account that is maintained by the same trustee. If you are preparing a return for a taxpayer who has made a Roth IRA conversion, additional research may be required. More information about a Roth IRA conversion can be found in IRS Publication 590, Individual Retirement Arrangements (IRAs). SIMPLE IRA A SIMPLE IRA is a retirement plan generally setup by small employers to allow employees to contribute pre-tax compensation into the plan. Employers are required to either make a matching contribution based on the employee s elective deferred compensation or a nonelective contribution that must be paid to all eligible employees, regardless of whether the employee makes contributions to their account. The employer receives a deduction on the business return for the contribution they made to the employee s accounts. Unlike a traditional IRA, the employee does not receive a contribution adjustment on their return, because their contributions are made by their employer on their behalf prior to calculating and remitting federal and state income tax. The employee taxpayers are then taxed on the SIMPLE IRA funds when they take distributions from the account. For more information, see IRS Publication 560, Retirement Accounts for Small Businesses. Complete Exercises 17.2 and 17.3 before continuing to read.

75 Retirement RETIREMENT SAVINGS CONTRIBUTION CREDIT Qualified lower- and middle-income taxpayers who make retirement plan contributions may be eligible to claim a nonrefundable credit on their tax returns. This Saver s Credit, for short, is available in addition to any allowable deduction which makes this one of the very few situations where a double benefit may be claimed. A 2015 Saver s Credit is not available to taxpayers who were: Born after January 1, The year changes each year. Claimed as a dependent on someone else s 2015 return. Full-time students during any part of five calendar months in Qualified Contributions Contributions that qualify for the Saver s Credit include: Contributions to traditional and Roth IRAs. (As with the traditional IRA deduction, contributions for 2015 made in 2015 give rise to a credit for 2015.) Voluntary salary deferrals to 401(k) plans, 403(b) tax-sheltered annuity plans, governmental 457 plans, SEPs, and SIMPLE plans. Voluntary employee contributions to qualified retirement plans. Contributions to 501(c)(18)(D) plans. While a thorough understanding of the details of each plan type is not necessary at this time, it is important to be aware of the types of plans that are available. Generally, when qualified contributions are made by an employee to an employer-maintained plan, they can be found in box 12 of their Form W-2 denoted by code D, E, F, G, H, or S. You may want to review the box 12 codes for Form W-2 (Illustration 17.2). Employers matching contributions do not count toward the credit. Also, mandatory contributions do not qualify for the credit. Contributions are considered mandatory if they are required as a condition of employment. mexample: Michael Oxenbacher (46) voluntarily deferred $1,000 of his salary into his employer s 401(k) plan. He also contributed $500 to a traditional IRA and $250 to a Roth IRA. All of these contributions are qualified contributions for the Saver s Credit.m

76 17.18 H&R Block Income Tax Course (2016) Contributions that qualify for the Saver s Credit must be reduced by any distributions from the same types of plans made in the two tax years prior to the current year until the due date of the current year s return (including extensions). Thus, for 2015, distributions made after December 31, 2012, and before April 15, 2016, (October 15, 2016, if an automatic six-month extension was requested) reduce the amount eligible for the credit. mexample: Suppose that Michael Oxenbacher (from the preceding example) had taken a $600 distribution from his 401(k) plan on January 8, His $1,750 qualified contributions must be reduced by the $600 distribution when computing the Saver s Credit.m The following do not reduce the amount eligible for the Saver s Credit: Distributions directly rolled over or transferred from one trustee to another. Distributions of funds converted from a traditional IRA to a Roth IRA. Loans from qualified employer plans treated as distributions. Distributions of excess contributions or deferrals (plus earnings). Distributions of contributions made during the tax year (plus earnings) and withdrawn before the due date of the return (including extensions). Distributions of dividends on stock held by an employee stock ownership plan. Distributions from a military retirement plan. mexample: On June 17, 2015, Robert Demler withdrew (i.e., took a distribution) $1,300 from his traditional IRA. On August 13, 2015, he rolled over the funds into a new traditional IRA. On December 3, 2015, he contributed $2,000 to the new IRA. Robert is not required to reduce his $2,000 contribution, which qualifies for the Saver s Credit, by the amount he rolled over in However, if he had kept the money from the original distribution, he would have been required to reduce his qualified contribution to $700 [$2,000 $1,300 = $700].m Amount of Credit The Saver s Credit is based on qualified contributions up to $2,000 per taxpayer or $2,000 for each spouse on a joint return in The credit rates are 10%, 20%, or 50%, depending upon filing status and modified AGI. In this case, AGI is modified only for certain excluded foreign and U.S. possession income. The rates are shown on the following page in Illustration 17.8.

77 Retirement Illustration 17.8 SAVER S CREDIT RATES Modified Adjusted Gross Income Married Filing Head of Household Jointly All Others Credit Rate Up to $36,500 Up to $27,375 Up to $18,250 50% $36,501 39,500 $27,376 29,625 $18,251 19,750 20% $39,501 61,000 $29,626 45,750 $19,751 30,500 10% Over $61,000 Over $45,750 Over $30,500 0% The credit is computed on Form 8880, Credit for Qualified Retirement Savings Contributions, shown in Illustration The credit is then entered on Form 1040A, line 34. mexample: Stephanie Ackerman (35) is a teacher using the head of household filing status. During 2015, she deferred $2,150 of her salary into her employer s 403(b) tax-sheltered annuity plan. On April 13, 2015, she contributed $4,000 to her Roth IRA for Back in 2013, she had withdrawn $750 from the Roth IRA when she was having a tough time making ends meet. Stephanie s modified AGI is $33,600, and her Form 1040A, line 28, amount is $1,799. Based on Stephanie s modified AGI, she qualifies for a $200 retirement savings contributions credit (Saver s Credit), which is reported on her Form 1040A, line 34. Her completed Form 8880 is shown in Illustration 17.9.m Complete Exercise 17.4 before continuing to read. SOCIAL SECURITY AND EQUIVALENT RAILROAD RETIREMENT BENEFITS Many taxpayers who are retired or disabled or whose spouses or parents are deceased receive social security or equivalent tier 1 railroad retirement benefits (RRB). Like many other amounts in tax law (such as the allowable standard deduction), social security benefit amounts are indexed for inflation, which generally results in the benefit amount increasing from year to year.

78 17.20 H&R Block Income Tax Course (2016) Illustration 17.9

79 Retirement Depending upon each taxpayer s situation, up to 85% of a taxpayer s social security or equivalent tier 1 RRB may be taxable. Taxpayers with income above a certain threshold will pay tax on a portion of their benefits. Note: For purposes of this section, the term social security benefits applies only to payments made under the Old-Age, Survivors, and Disability Insurance (OASDI) program. OASDI benefits are funded through the social security payroll tax, are based upon prior earnings, and may be partially taxable. Social security benefits do not include Supplemental Security Income (SSI). SSI is a federal program providing income assistance based on financial need for the aged, blind, and disabled. While the Social Security Administration administers both programs, SSI benefits are not taxable. Full Retirement Age For workers born before 1938, full retirement age is age 65. The retirement age is gradually being increased to age 67 for workers born after The table in Illustration shows how this change is being phased in. Barring change, the entire process will be complete in Illustration FULL RETIREMENT AGE Year of Birth Full Retirement Age Year of Birth Full Retirement Age 1937 and earlier 65 years years years, 2 months years, 2 months years, 4 months years, 4 months years, 6 months years, 6 months years, 8 months years, 8 months years, 10 months years, 10 months The full retirement age is 67 years for everyone born in 1960 and later. Reporting Social Security and Equivalent Railroad Retirement Benefits Form SSA-1099 is used to notify the taxpayer of total social security benefits received during the year. This form is shown in Illustration Form RRB-1099 is used to notify the taxpayer of tier 1 RRB received during the year. This form is shown in Illustration

80 17.22 H&R Block Income Tax Course (2016) Illustration Illustration 17.12

81 Retirement Study Form SSA-1099, Social Security Benefit Statement, in Illustration and Form RRB-1099 in Illustration as you read through the next section describing the forms. Note: There are minor differences between the forms. The following references are for the SSA Box 1. Recipient s name. Box 2. Recipient s social security number. Box 3. Total amount of benefits paid. This figure may not agree with the actual money the taxpayer received, due to adjustments for items withheld, such as Medicare Part B premiums. All adjustments are itemized in the box labeled Description of Amount in Box 3 (SSA-1099). Box 4. Recipients who have not yet reached full retirement age and who earned more than $15,720 in wages and net self-employment income during 2015 may be required to pay some of their benefits back to the Social Security Administration. Box 4 shows the total amount of benefits repaid, if any. The earnings limit, above which some benefits may need to be repaid, is $41,880 for taxpayers who reached full retirement age in There is no earnings limit for recipients who reached full retirement age before Box 5. Net benefits received. This amount is the difference between the figure in box 3 and the figure in box 4. Box 6 (Box 10 on RRB-1099). Taxpayers may choose to have federal income tax withheld from their benefits. The amount of tax withheld is shown here and should be included on Form 1040A, line 40. Computing Taxable Benefits The amount of a taxpayer s social security or tier 1 RRB subject to federal tax varies from zero to 85%, depending upon filing status and income. The level of taxability is based on modified AGI (defined below) increased by one-half of the net benefits received by the taxpayer (and spouse, if MFJ). See Illustration for the taxability ranges. Illustration Filing Status TAXABLE SOCIAL SECURITY BENEFITS None of Benefits Taxable Up to 50% of Benefits Taxable Up to 85% of Benefits Taxable S, HH, QW $0 25,000 $25,001 34,000 $34,001 & over MFJ $0 32,000 $32,001 44,000 $44,001 & over MFS* $1 & over * If married filing separately and did not live with spouse at any time during the year, use single.

82 17.24 H&R Block Income Tax Course (2016) Tax Tip: Here is a handy rule of thumb to help determine if a portion of social security or RRB benefits are taxable: generally, if 50% of the total benefits plus all other income do not exceed $25,000 ($32,000 MFJ, $0 if MFS and the taxpayers lived together at any point during the year), none of the benefits are taxable. Modified adjusted gross income is the sum of the following: Regular AGI (without taking any social security or RRB tier 1 benefits into account). Any excluded employer-provided adoption benefits. Tax-exempt interest (for example, municipal bond interest). Any interest from qualified U.S. Savings Bonds excluded because the taxpayer has qualified education costs. Any excluded foreign earned income or housing allowance, or certain U.S. possession income. Any student loan interest deduction. Any tuition and fees deduction. Any domestic production activities deduction. H&R Block provides a worksheet you will use to determine the taxable amount of social security benefits. The BlockWorks Social Security Taxable Benefits Worksheet is shown in Illustration The worksheet looks intimidating, but don t worry it is very easy to use if you read each line carefully and follow the instructions. The taxable amount of the social security or RRB income appears on line 19 of the worksheet. If line 19 of the worksheet shows that some of the benefits received are taxable, enter the taxable amount on Form 1040A, line 14b. Also, enter the benefits received (line 1 of the worksheet) on line 14a. If line 19 of the worksheet shows that none of the benefits received are taxable, enter net benefits for this income on Form 1040A, line 14a, and enter $0 on line 14b. If the taxpayer is married filing a separate return and did not live with their spouse at any time during the year, they would also enter D in the space to the left of line 14a and enter $0 on line 14b. mexample: Samuel and Carol Walters are filing a joint return. Their Form 1040A, before calculating taxable social security, shows AGI of $50,000, made up of the following entries: Line 7 (wages) $40,000. Line 8a (taxable interest) $10,000. They also received nontaxable municipal bond interest of $2,000 (Form 1040A, line 8b). Box 5 of Sam s Form SSA-1099 shows $6,000. On Form 1040A, $6,000 is entered on line 14a, and $5,100 is entered on line 14b. The Walterses Social Security Taxable Benefits Worksheet is shown in Illustration m

83 Illustration Retirement 17.25

84 17.26 H&R Block Income Tax Course (2016) Tier 1 Railroad Retirement Benefits Generally, social security benefits and tier 1 RBB receive the same tax treatment. However, railroad retirement disability benefits that are payable to individuals who would not be entitled to social security disability benefits, or that are in excess of the social security benefits to which an individual would be entitled, generally are fully taxable. Similarly, railroad retirement benefits that are payable at an age earlier than comparable social security benefits, or in an amount greater than the social security benefits, are generally fully taxable. See IRS Publication 575, Pension and Annuity Income, for more information. Railroad retirement benefits described in this paragraph are reported to the taxpayer on Form RRB-1099-R (rather than on Form RRB-1099) and are treated as pension income. Pension income is discussed in the next section. Complete Exercise 17.5 before continuing to read. RETIREMENT ACCOUNT DISTRIBUTIONS A distribution is when a taxpayer takes money out of a retirement account. Generally, distributions from pensions, annuities, profit-sharing and retirement plans (including 457 state and local government plans), IRAs, insurance contracts, etc., are reported to the recipient taxpayer on Form 1099-R, Distribution From Pension, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. This form is shown in Illustration Illustration 17.15

85 Retirement Study Form 1099-R in Illustration as you read through the next section describing this form. Box 1. Gross distribution. This is the gross amount the taxpayer received for the year. Box 2a. Taxable amount. This is generally the taxable portion of the amount received. If there is no entry in this box, the payer may not have all the facts needed to figure the taxable amount. In that case, the first box in box 2b, taxable amount not determined, should be checked. Box 2b. Taxable amount not determined. If the first box is checked, the payer was unable to determine the taxable amount, and box 2a should be blank, except for an IRA. In that case, the recipient must compute the taxable amount. Box 2b. Total distribution. If the total distribution box is checked, all the funds in the account were distributed to close out the account. A lump sum distribution or rollover could trigger a total distribution of account funds. Box 3. Capital gain (included in box 2a). If the participant was in the plan prior to 1974, this portion of the distribution may be eligible for the capital gain election. See the instructions for Form 4972 or IRS Publication 575. Box 4. Federal income tax withheld. If any federal tax has been withheld, the amount is shown here. Include this amount on Form 1040A, line 40. Box 5. Employee contributions or insurance premiums. This box may contain the amount of the employee s after-tax contributions to the plan. If the Form 1099-R is for a pension rather than a total distribution, the total employee contributions should be shown in box 9b in the first year of periodic payments. For succeeding years, any amount shown in box 5 will be the amount of employee contributions recovered tax-free during the year. Box 6. Net unrealized appreciation in employer s securities. Net unrealized appreciation (NUA) is the untaxed increase in value in employer s securities received as part of the distribution. This amount generally is not taxed until the securities are sold. If you encounter a Form 1099-R with an entry in box 6, you will need to do some reading about net unrealized appreciation. Here again, the instructions for Form 4972 will give you a good start. Box 7. Distribution code(s). As you know, this box contains one or two codes that describe the distribution. Although there may be both a number and a letter entered in box 7, there generally should be no more than one of each.

86 17.28 H&R Block Income Tax Course (2016) With all of the different types of distributions that can be reported on Form 1099-R, the list of codes has grown quite long. Here is a list of the more common ones, along with their meanings for A complete list of codes can be found on the back of copy C of Form 1099-R. If you encounter a Form 1099-R with a code you do not understand, you will need to do some research or consult with a more experienced Tax Professional: 1 Early distribution; no known exception to penalty applies (as far as the payer knows). 2 Early distribution; exception to penalty applies (for example, conversion to a Roth IRA). 3 Disability. 4 Death (includes payments to a beneficiary). 7 Normal distribution. A May qualify for ten-year averaging and/or capital gain election (as far as the payer knows). G Direct rollover to a qualified retirement plan, tax-sheltered annuity, 457(b) plan, or IRA, or from a conduit IRA to a qualified plan. J Early distribution from a Roth IRA, no known exception to penalty applies (as far as the payer knows). Q Qualified distribution from a Roth IRA. T Roth IRA distribution due to death or disability or taxpayer has reached age 59½, but the payer does not know if the five-year holding period was met. Box 8 is used to show the current actuarial value of an annuity contract. This amount may be needed for Form Box 9a is used when the total distribution is made to more than one person. The taxpayer s percentage of the total distribution is shown here. Box 9b shows the amount of the employee s total investment in the retirement account. This amount is used to compute the taxable portion of the distribution. Boxes State and local tax information. Any state or local income tax withheld will be shown in boxes 12 and 15, respectively. Enter these amounts on the appropriate lines of the state and local tax returns. Also, include them in itemized deductions on line 5 of federal Schedule A, if the taxpayer itemizes and does not elect instead to deduct state and local general sales taxes. If the state or local distribution amount is different from the federal amount, the appropriate amounts will be shown in boxes 14 and 17, respectively. TAXABLE DISTRIBUTION Distributions from a qualified retirement account are generally fully or partially taxable because the retirement account was funded with pre-tax contributions and the earnings grew tax-free while in the account.

87 Retirement A fully taxable distribution is a distribution where the taxpayer did not make after-tax contributions, or from which all after-tax amounts have been recovered in previous years. If the taxpayer made no contribution to the pension plan or annuity (for example, the employer paid all the costs), or if the taxpayer made only pre-tax contributions to a plan (such as in a 401(k) plan), the entire distribution amount received during the year is taxable. Examine line 12 on the first page of Form 1040A. When a distribution from a retirement account, excluding an IRA, is fully taxable, enter the total amount directly on line 12b and make no entry on line 12a. mexample: Harry Murphy (67) receives a fully taxable monthly distribution from his 401(k) of $1,600 ($19,200 annually). His Form 1099-R is shown in Illustration Harry's fully taxable 401(k) distribution of $19,200 is reported on his Form 1040A, line 12b.m A partially taxable distribution is a distribution where the taxpayer has made after-tax contributions to the retirement account. When the taxpayer receives a distribution from this account, a portion of the distribution represents a nontaxable return of their after-tax contribution (investment or cost). Fortunately, most payers will have the required information to compute the taxable amount of the distribution and report it to the recipient on Form 1099-R, box 2a. For payers who do not know the amount of after-tax contributions made by the taxpayer, the payer will leave box 2a blank and check box 2b, taxable amount not determined. In this situation, the taxpayer is required to determine their taxable amount of the distribution. When reporting a partially taxable distribution from a retirement account, excluding an IRA, the total distribution amount received for the year is entered on Form 1040A, line 12a. The taxable amount is entered on Form 1040A, line 12b. There are several methods for computing the taxable amount of a partially taxable distribution. Which one you will use depends mostly on when the payments started. The methods have undergone considerable changes over the years, but we will concentrate on the most recent rules. The older general rule will be presented later for your awareness. Simplified Method The simplified method may be used to compute the taxable portion of a pension or annuity with a starting date after July 1, 1986, and before November 19, 1996, where the taxpayer has after-tax contributions in the plan. However, taxpayers are required to use the simplified method if their pension or annuity starting date is after November 18, The pension or annuity must meet the following three conditions to use the simplified method: The payments must be from a qualified pension, profit-sharing, or stock bonus plan; a qualified employee annuity plan; or a tax-sheltered annuity (403(b) plan). The annuitant (the receiver of the payments) must be under 75 years of age when the payments begin, or, if 75 or older, there must be fewer than five years of guaranteed payments. The payments are for either the annuitant s life or the joint life of the annuitant and a beneficiary.

88 17.30 H&R Block Income Tax Course (2016) Under the simplified method, the taxpayer s excludible amount is determined by using a simple table. The table included on the Simplified Method Worksheet shows the anticipated number of monthly payments based on the age of the annuitant(s) for a pension or annuity starting after November 18, Note, the joint and survivor columns are to be used only for pensions and annuities starting after December 31, The age of the taxpayer is their age on the date the pension payments begin. This is important to note since often a pension will begin in a year before the taxpayer reaches their full retirement age. mexample: Thomas Bloom s birthday is November 15, His first pension payment was made on March 1, Therefore, the age to use for the table is 64, as he would not reach age 65 until November 15, 2015.m The taxpayer s after-tax investment, or cost in the pension or annuity, is divided by the appropriate number from the table to determine the excludible amount of each payment. For partly taxable pensions and annuities with starting dates after December 31, 1986, part of each payment received is excludible until the taxpayer has recovered their cost. Once the cost is recovered, the pension or annuity is fully taxable. If the taxpayer (and their beneficiary, in the case of a joint and survivor annuity) dies before the cost has been fully recovered, the unrecovered amount is deducted on the taxpayer s (or beneficiary s) final return as a miscellaneous itemized deduction on their Form 1040, Schedule A. The excludible amount of each payment never changes (until it ceases entirely when the final beneficiary dies or the cost is fully recovered), even though the annuity or pension payments may increase due to cost-of-living provisions or for other reasons. mexample: George Castle (69), a single taxpayer, began receiving a pension of $1,500 per month for life from the Leisure Retirement Funding Pension Fund on March 1, His Form 1099-R is shown in Illustration George s after-tax investment in the pension was $74,100. In 2015, he recovered $3,529 of his investment ($ per month for ten months). George s Simplified Method Worksheet is shown in Illustration He will report $15,000 on line 16a (12a) and $11,471 on line 12b of his 2015 Form 1040A.m B lockworks tip: When entering a partially taxable qualified retirement plan or traditional IRA distribution into BlockWorks, scroll to the bottom of the pension input screen in BlockWorks. Here, you will make entries to compute the taxable amount using the simplified method. Table 1 is used unless the spouse is a beneficiary of the pension, in which case Table 2 is used and the sum of both taxpayers ages is entered in the Age at starting date box, such as in Illustration

89 Retirement General Rule The general rule for calculating the excludible portion of pension and annuity payments may be used if a taxpayer started receiving payments before November 19, If the taxpayer started receiving payments on or after that date, the simplified method must be used in most cases. In cases of purchased annuities and other nonqualified plans, the general rule must be used regardless of the annuity starting date. Because the general rule involves using complex actuarial tables, we will not discuss it in this course. If you encounter a pension or annuity that must be (or is being) recovered using the general rule, you will need to do some research and partner up with an experienced Tax Professional. IRS Publication 939, General Rule for Pensions and Annuities, is a good place to start. There was also a death benefit exclusion available for certain beneficiaries of pensions and annuities in the past. This exclusion was repealed for deaths occurring after August 20, If you ever need more information about this exclusion, see IRS Publication 939, General Rule for Pensions and Annuities. Complete Exercise 17.6 before continuing to read. Illustration 17.16

90 17.32 H&R Block Income Tax Course (2016) Illustration 17.17

91 Retirement Illustration IRA DISTRIBUTIONS Distributions from traditional and Roth IRAs are also shown on Form 1099-R. If a distribution is from an IRA (or a SEP or a SIMPLE IRA), an appropriate code will be entered in box 7, and the small box to the right of box 7 will be checked. Traditional IRAs. Distributions from traditional IRAs are usually reported on Form 1099-R as fully taxable because the IRA trustee does not know how much, if any, of the taxpayer s IRA contributions were nondeductible. Sometimes, the Taxable amount not determined box is checked. If any nondeductible contributions had been made, the taxpayer must use Form 8606 to compute the taxable portion of any distributions. If the IRA distribution is fully taxable, enter the full amount on Form 1040A, line 11b. If the distribution is partly taxable, enter the gross amount on line 11a and the taxable portion on line 11b. mexample: Mildred Zigler (69), a single taxpayer, withdrew $3,000 from her traditional IRA on December 11, She made no contributions to her traditional IRA in Mildred has an $800 basis in her IRA from a nondeductible contribution she made in 1998 (report on Form 8606, line 2). According to her IRA trustee statement, her IRA was worth $17,582 at the end of 2015 (report on Form 8606, line 6). Mildred s Form 8606 is shown in Illustration After completing Form 8606, Mildred will enter $3,000 on Form 1040A, line 11a and $2,883 on line 11b. The amount on line 14 of her Form 8606 is her remaining basis, and she will carry it to line 2 (unless the line number changes) of the next Form 8606 she files.m Roth IRAs. Qualified distributions from Roth IRAs are exempt from tax. A qualified distribution is one that: Is taken after the end of the five-year period that began January 1 of the tax year for which the account was set up. Is made after the account owner has died, becomes disabled, or reaches age 59½ or is used to buy, build, or rebuild the taxpayer s first home. Part III of Form 8606 (on page 2, which is not shown) is used to determine the taxable amount of any nonqualified distribution. If you need additional information, see IRS Publication 590. Complete Exercise 17.7 before continuing to read.

92 17.34 H&R Block Income Tax Course (2016) Illustration 17.19

93 Retirement EARLY DISTRIBUTIONS FROM QUALIFIED RETIREMENT PLANS The Tax Code imposes an additional 10% early withdrawal penalty tax on the taxable portions of most early distributions from qualified retirement plans and IRAs. An early distribution generally is one made before the taxpayer has reached age 59½ and is denoted by code 1 in box 7 of Form 1099-R. The 10% early withdrawal penalty is only reported on Form There are, however, several exceptions (shown below) to the penalty available. The penalty does not apply to the recovery of cost (investment) or any amount rolled over in a timely manner. See the IRS Publication 590-A, Contributions to Individual Retirement Arrangements (IRAs) for a full discussion of IRA rollovers. mexample: On June 4, 2015, Nahima Meda (33) left her job and took a total distribution from her 401(k) plan. Her Form 1099-R shows a fully taxable distribution of $9,700. She did not roll over any of the money. The early distribution is also subject to a 10% penalty tax.m The early distribution penalty is sometimes computed in Part I of Form 5329, shown in Illustration There are several exceptions to the penalty. If any of these apply, a code is entered on Form 5329, line 2. The penalty will not apply in the following cases. Note: Exceptions 01 and 06 do not apply to IRAs. Exception 02 applies to IRAs and to employer plans, but only if the taxpayer no longer works for that employer. Exceptions 07, 08, and 09 apply only to IRAs. 01 The distribution was made to an employee who separated from service during or after the year in which they reached age 55 (age 50 for qualified public safety employees). 02 The distribution is part of a series of substantially equal periodic payments, made at least annually for the life of the participant (or joint lives of the participant and beneficiary) or the life expectancy of the participant (or the joint life expectancies of the participant and beneficiary). 03 The distribution was made due to permanent and total disability. 04 The distribution was made due to the death of the employee. 05 The distribution was made in a year that (and to the extent that) the taxpayer s unreimbursed medical expenses exceed 10% (7½% if taxpayer or spouse is age 65 or older) of adjusted gross income (whether the taxpayer itemizes or not). 06 The distribution was made to an alternate payee under a qualified domestic relations order (usually a separation agreement or divorce decree). 07 The distribution was made from an IRA in a year (and to the extent that) an unemployed taxpayer paid health insurance premiums. 08 The distribution was made from an IRA to pay qualified higher education expenses for the taxpayer, spouse, their child, or their grandchild (whether or not the student is the taxpayer s dependent). 09 The distribution (up to $10,000 lifetime limit) was made from an IRA to pay qualified firsttime homebuyer expenses. 10 The distribution was made due to an IRS levy of the qualified plan. 11 The distribution was made to a reservist while serving on active duty for at least 180 days. 12 Other. For other exceptions, refer to the instructions for Form Also, use this code if more than one exception applies. For additional exceptions applicable to annuities, see IRS Publication 575 or the instructions for Form 5329.

94 17.36 H&R Block Income Tax Course (2016) (2015) Further explanation on some of the exceptions may be helpful at this point. Age 55. Observe carefully the wording of exception 01. The recipient must have separated from the service of their employer before receiving the distribution. They need not have actually reached their 55th birthday prior to the separation, as long as they do so by the end of the year. Medical expenses. Exception 05 does not require that the money from the distribution itself be used to pay the medical expenses simply that the taxpayer s medical expenses for the year exceed 10% of AGI (7½% if taxpayer or spouse is age 65 or older), even if the taxpayer doesn t itemize. This exception may apply to all or part of the distribution. mexample: Alan Trimble is 40 years old and has an AGI of $40,000, including his $5,000 early IRA distribution. His unreimbursed medical expenses total $4,800. Alan can escape penalty on $800 using exception 05 [$4,800 ($40, % = $4,000) = $800].m Unemployed taxpayers. To qualify for exception 07, the distribution must be made to a taxpayer who has received unemployment compensation payments for 12 consecutive weeks. This exception does not apply to any distribution made more than 60 days after the taxpayer has returned to work. This exception only applies to IRAs. Qualified higher education expenses, for the purpose of exception 08, has the same meaning as for the education credits, plus room and board if the student is enrolled on at least a half-time basis. The expenses must be paid for the taxpayer, the spouse, or the child or grandchild of the taxpayer or spouse. The child or grandchild need not be the taxpayer s dependent. mexample: In 2015, Carmen DiGiorgio (43) took $5,000 out of his traditional IRA to pay toward his son s college tuition. The distribution is fully taxable, but not subject to the 10% penalty. His Form 5329 is shown in Illustration m Qualified first-time homebuying expenses, for the purpose of exception 09, are any costs of acquiring or constructing a principal residence for a first-time homebuyer. The term first-time homebuyer is misleading; what it really means is someone who has not owned a home during the two-year period prior to the date of acquisition of the home to which this exception applies (up to $10,000). The distribution must be used to pay qualified expenses within 120 days after the date of distribution. The expenses must be paid for the taxpayer, spouse, their child or their grandchild, or parent or grandparent. Five-year period. A Roth IRA distribution (up to $10,000) used to pay first-time homebuying expenses not only meets the penalty exception but is not subject to taxation at all if it was made after the end of the five-year period beginning with January 1 of the year for which the first contribution was made. So, for example, if you first contributed to a Roth IRA for 2009, you could take a qualified distribution of up to $10,000 to buy your first home any time after 2013 and pay no tax or penalty! The second page of Form 5329 contains a taxpayer signature section. The taxpayer (and paid preparer, if any) needs to sign Form 5329 and complete the address on page 1 only if the form is not attached to a tax return, but is sent to the IRS by itself. That could happen, for example, if the taxpayer does not meet the gross income filing requirements but had an early distribution subject to the penalty.

95 Illustration X.X Retirement 17.37

96 17.38 H&R Block Income Tax Course (2016) (2015) If the only penalty a taxpayer owes is the 10% penalty for an early distribution, and their Form R correctly shows code 1, Form 5329 need not be completed if they meet none of the exceptions. Such taxpayers may enter the 10% penalty directly on Form 1040, line 59, and write No to the left of the line under the heading Other Taxes, indicating that there is no Form 5329 attached. Complete Exercise 17.8 before continuing to read. In this chapter, you learned how to: CHAPTER SUMMARY Explain the features of commonly available retirement accounts and the tax benefits of contributing to these retirement accounts. Determine if a taxpayer is eligible to contribute to a traditional or Roth IRA as well as determine if their traditional IRA contributions were deductible. Determine a taxpayer s eligibility for the retirement savings contribution credit and calculate the amount of the retirement savings contribution credit. Determine and accurately report the taxable portion of social security or tier 1 railroad retirement benefits. Identify and accurately report taxable qualified retirement plan and IRA distributions. Explain the consequences of early retirement plans and IRA distributions. Suggested Reading For further information on the topics discussed in this chapter, you may wish to read the following sections in IRS Publication 17: Chapter 10, Retirement Plans, Pensions, and Annuities. Chapter 11, Social Security and Equivalent Railroad Retirement Benefits.

97 Retirement The Tax Institute Tax in the News Research Question: Our client turned 55 in 2015 and took three early distributions from three different 401(k) plans during Two of the 401(k)s are with his two former employers, and one is with his current employer. Can the age 55 exception apply to all three distributions, or only to the two from the client s previous employers? Answer: From the facts you have given, all three of the 401(k) distributions are subject to the 10% early distribution penalty. In order to apply the 72(t)(2)(A)(v) age 55 penalty exception to an early distribution from a retirement plan, two conditions must be met: 1. The distribution must be made to an employee after he or she has separated from service with the employer maintaining the plan. 2. The separation must occur during or after the calendar year in which the employee attained age 55. Unfortunately, many taxpayers do not understand this second condition. They mistakenly believe that as long as they are either retired or no longer working for a particular employer, they are free to begin taking distributions from their former employer s plan once they turn 55. The second condition means that if the separation from service occurs before the year the employee turned 55 whether because of retirement, changing jobs, a lay-off, etc. the age 55 exception does not apply to that employer s plan. While the distributions from your client s former employers meet the first condition, i.e., they were made after he separated from service, they do not meet the second condition because he left those companies before the year in which he turned 55. The distribution from your client s current employer s plan clearly does not qualify for the exception because he has not separated from service for this employer. Thus, the three distributions are subject to the early withdrawal penalty unless another exception applies. Note: It is not clear why your client was able to take a 401(k) distribution from his current employer. In general, a plan distribution is not permitted unless an employee has reached age 59½, or has left the employer, or is eligible for a hardship distribution. Plans may allow hardship distributions for certain contingencies, but they are subject to the early distribution penalty.

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99 18 Ethics OVERVIEW The ethical decision is always the fearsome decision. When something matters enough that we are afraid of the consequences afraid that even the honorable choice could result in harm or loss or sorrow that s when ethics are involved. Henry W. Bloch Ethical behavior is taking responsibility for personal conduct. Ethical rules and regulations established by the IRS and other agencies provide the guidelines for tax preparers. This chapter will inform you of the basic guidelines and show you how to apply those guidelines at the tax desk. This responsibility extends beyond satisfying individual responsibilities, and beyond the requirements of society s laws and regulations. Ethical behavior recognizes a responsibility to the taxpayer, to fellow tax preparers, and to H&R Block, even if this behavior requires personal sacrifice. The underlying reason for a high level of ethical conduct by any professional is the need for public confidence in the quality of service by the professional, regardless of the individual providing the service. Our business is built from the relationships we create and maintain with H&R Block clients, other tax preparers, and regulatory agencies. It is important that we follow the principles that set the foundation for ethical standards in our business practices OBJECTIVES At the conclusion of this chapter, you will be able to: Define due diligence. Identify scenarios that present a conflict of interest. State key requirements of client confidentiality. Identify situations of noncompliance and respond appropriately. Perform best practices that fulfill ethical requirements. TAX TERMS Look up the definitions of the following terms in the glossary: Circular 230 Disclosure Due diligence Noncompliance Privilege 18.1

100 18.2 H&R Block Income Tax Course (2016) DUE DILIGENCE Due diligence is required by all tax preparers to ensure that the Tax Code is correctly applied in all matters. Taxpayers do not know tax law. They come to tax preparers for guidance and expertise that help them comply with their tax obligations. It is up to the tax preparer to apply due diligence accordingly. Specific situations in which tax preparers must exercise due diligence include: Preparing, reviewing, and filing tax returns and other documents related to IRS matters. Determining the correctness of oral or written representations the tax preparer makes to the Department of the Treasury. Determining the correctness of oral or written representations the tax preparer makes to clients with reference to any matter administered by the IRS. Accurate and Complete Tax preparers must prepare accurate and complete returns. A tax return is accurate and complete when all income is included and the taxpayer qualifies for all deductions and credits that are claimed. It is a primary due diligence responsibility to know the tax law and use sound judgment to determine eligibility. An ethical tax preparer completes every tax return accurately and completely. This attempt is made regardless of such factors as EITC implications or taxpayer reluctance to provide accurate and complete information. Defining Error and Fraud Occasionally, in spite of our best efforts, taxpayers make mistakes on the information they provide. Tax law provides ways to correct errors. Correspondence with the IRS, either by letter or by an amended return, will correct accidental tax errors. If taxpayer gives information to purposely deceive the IRS, this behavior is fraud and cannot be tolerated. Do not sign a return that is fraudulent. Do not assist a taxpayer in unlawful activity. A tax preparer may not: Sign a tax return that is frivolous (obviously improper or unlawful). Take a position advising a change on a tax return that does not have a greater than 50% likelihood of being sustained on its merits. Under tax law, to perform your duties as a paid tax preparer, you may occasionally have to explain to a taxpayer that their cooperation is required before you can continue to prepare their tax return. If a taxpayer does not have receipts or documentation for business expenses and refuses to reconstruct them or obtain substitute records, you cannot sign the return. There is a difference between a taxpayer who is overwhelmed by other responsibilities and one with an intent to commit fraud. It is your responsibility to apply a reasonability check to determine the reality.

101 Thorough Interview Ethics 18.3 A thorough interview consists of asking questions whenever information is incomplete or seems inaccurate or inconsistent. The client s answer to one question might often lead a tax preparer to ask a follow-up question. It is an interesting fact of tax preparation that each client brings a unique set of circumstances. A tax preparer might ask the same question to several different clients, but should never expect the same answer. Likewise, similar answers might have different outcomes based on other factors on the return. Reasonablility Check A reasonability check is when a tax preparer considers the client s information before making any conclusions. A reasonability check should be applied to the client s individual answers and to their whole tax picture. A tax preparer should look at all the factors and ask, Does this make sense? Do not sign a return that has not met your reasonability check, and make sure to complete a thorough interview in every case. The IRS requires that you document the questions and answers asked about the significant issues on the return, especially on a return which includes a significant benefit from EITC. Tax Tip: It is not the tax preparer s responsibility to audit taxpayer records. Applying due diligence is not auditing it is the process through which a thorough interview culminates in an accurate and complete return. Appropriate application of due diligence provides an accurate and complete return that ensures: All income is reported. The taxpayer meets all required criteria for claiming: Dependency exemptions. Credits and deductions. Similar items. Contemporaneous Records The contemporaneous records requirement of due diligence is the immediate documentation of your questions and each taxpayer s responses. Although it is specifically required on all EIC claims, tax preparers should always document their questions and the client s answers if they think the IRS might question any item on the return. tax preparers can use the Notes section in their software to include any explanation or additional information that they think the IRS might question. See Illustration 18.1 on page Note: Taxpayers must have access to anything entered into their tax return or tax file. Therefore, the notes should be written in a professional manner.

102 18.4 H&R Block Income Tax Course (2016) Illustration 18.1 Tax Tip: The contemporaneous records requirement pertains to information that the IRS may need to understand the taxpayer s circumstances. In the words of an IRS speaker at a recent IRS forum, If it isn t documented, it didn t happen! Complete Exercise 18.1 before continuing to read. CONFLICT OF INTEREST Conflicts of interest can arise in many situations. A conflict may be present from the moment a relationship is initiated with a client, or the conflict may develop well after work has started with a client. In either case, tax preparers must be diligent in acknowledging that a conflict could or has occurred, and take appropriate actions to resolve the situation. Circular 230 and the H&R Block Code of Ethics expressly deal with conflicts of interest. Both documents prohibit or strongly discourage conflicts of interest across many situations, including: Client representation. Relations with customers, competitors, suppliers, co-workers. Political and investment activities.

103 Ethics 18.5 Circular 230 provides that a tax preparer is not allowed to represent a client before the IRS if a conflict of interest exists. Examples of situations where a conflict of interest exists include: One client will be adversely affected by representation of another client. mexample: Simon and Felicia are married. During a meeting with their tax preparer, Sam, they disclose having profound financial problems, and that they are seriously considering divorce. They also tell Sam that Simon s small business is failing and may close, and they may have to file for personal bankruptcy. If Simon and Felicia stay married, a conflict of interest will not exist. However, if they divorce, a conflict could exist because the best interests of Simon and Felicia may not be the same. In fact, they could be opposite. If Simon and Felicia divorce, Sam must explain to both of them what a conflict of interest is and that one has arisen in their case. He must also ask if they want to waive the conflict and continue with him as their representative, or one or both cease their relationship with him and find new representatives. If they decide to waive the conflict, Sam must obtain separate, signed waivers from both Simon and Felicia.m A significant risk that representation of one or more clients will affect the tax preparer s responsibility to other clients. mexample: Carmen is an enrolled agent with a successful tax practice. Carmen works alone. Because of increased compliance activity by the IRS, Carmen has increased her audit caseload by 100% over the prior year. She works 60 to 70 hours per week just representing her audit clients. Carmen may only take on additional tax return preparation or audit clients if she can do so without harming her existing clients. While not impossible, it is not reasonable to believe Carmen can increase her workload above 70 hours per week and still effectively serve all of her clients.m The tax preparer has a personal interest in the outcome. mexample: A tax preparer advertises that they can get the maximum refund for clients and charges a fee based on a percentage of the refund.m Exceptions to Conflict of Interest Rules When a conflict of interest is acknowledged, a tax preparer may still represent the clients under the following circumstances: The tax preparer reasonably believes they can provide competent and diligent representation to each affected client. The representation is not prohibited by law. Each affected client gives informed consent, confirmed in writing, stating that they waive the conflict. The IRS requires tax preparers who obtain written conflict of interest waivers from clients to retain the waivers for at least 36 months from the date the representation concludes, and to provide the waivers to the IRS upon request. Complete Exercise 18.2 before continuing to read.

104 18.6 H&R Block Income Tax Course (2016) CLIENT CONFIDENTIALITY It is a requirement that all tax returns and tax return information shall remain confidential. A tax return, for this purpose, includes: All types of tax returns. Tax information forms (for example, Forms W-2, 1099, or 1098). Declaration of estimated tax. Supporting schedules, attachments, or lists filed with the IRS. Tax return information includes: A taxpayer s identity. The nature, source, and amount of income. Payments, receipts, deductions, exemptions, credits, assets, liabilities, net worth, tax liability, tax withheld, deficiencies, over-assessments, and tax payments. Any other data received, recorded, prepared, or furnished to the IRS, or furnished or collected by the IRS. The information that a taxpayer is the client of a tax preparer or tax preparation business is confidential and must not be disclosed without the taxpayer s express consent. Privileged Communications Certain communications between attorneys or other authorized tax preparers and their clients are privileged. This means that clients may instruct their tax preparer to refuse to share specific communications and information with the government. The scope of privilege depends on the status of the tax preparer and their relationship to the client. There are two levels of privilege in the field of taxation: Attorney-client privilege exists between attorneys and their clients. Clients may assert this privilege to protect confidential communications and information. Attorneys are professionally obligated to raise this privilege on behalf of their clients, unless the client instructs otherwise. I.R.C privilege applies to communications and information between certain federally authorized tax preparers and their clients. Specifically, for I.R.C. 7525, federally authorized tax preparers are those with one of the following designations: Attorney. Certified public accountant (CPA). Enrolled agent (EA). Enrolled actuary. Appraiser.

105 Ethics 18.7 Privilege Under 7525 Is Narrow The 7525 privilege exists between any federally authorized tax preparer (listed above) and their client. This privilege is narrow in scope. It applies only to tax advice, not to tax return preparation. It also does not apply to state tax matters, criminal tax matters, or corporate tax matters. Limited Disclosure A tax preparer must not provide a copy of a taxpayer s tax return to any other party. In specific circumstances, tax preparers may disclose confidential tax return information. The most common exceptions are the: Related party exception In situations where tax preparers are preparing tax returns for two or more related parties, they may use information obtained from the first return and disclose it to the second party in the form it appears in order to prepare the second return. The taxpayers are related parties and: The first taxpayer s interest in the information is not adverse to the second taxpayer. The first taxpayer has not expressly prohibited the disclosure or use of the information. Written consent exception Tax Tip: Related parties for the purposes of the related party exception include husband and wife, parent and child, grandchild and grandparent, partner and partnership, trust or estate and beneficiary, trust or estate and fiduciary, corporation and shareholder, or members of a controlled group of corporations. A tax preparer may disclose otherwise confidential information of a taxpayer if he or she obtains written consent. The written consent must be dated and signed by the taxpayer, and express consent must be one of the following situations: To a third person as directed by the taxpayer. In preparing a tax return for a second taxpayer, not a related party. To other tax preparers or administrative personnel employed by the same tax preparation firm to the extent necessary for quality or peer review and processing the return. Tax Tip: A tax preparer should release a joint return to either or both spouses named as the taxpayers, because the return belongs to each spouse.

106 18.8 H&R Block Income Tax Course (2016) mexample: Jerry, a tax preparer, receives a call from Samantha, another tax preparer who works in a different office for the same company. Samantha is preparing a return for a prior client of Jerry s, and she needs some information not available on the prior year s return. Jerry does not know Samantha. Jerry should take the following actions: After learning what information Samantha needs, tell her he will call her back and ask for her phone number. Use a reliable source, such as an internal list, a phone book, directory assistance, or the internet, for the correct phone number of the office from which Samantha said she was calling. Compare the number with the one provided by Samantha. Call the number found at a reliable source and ask for Samantha. After positively identifying Samantha, release the information to her.m Registered Tax Return Preparers For federal tax purposes, no privilege exists between a client and a tax preparer who is a Registered Tax Return Preparer. A tax preparer who is a Registered Tax Return Preparer must promptly respond to proper requests for records and information. The Registered Tax Return Preparer must: Not neglect or refuse to submit available records and information upon a lawful and proper request by the IRS. Not interfere or attempt to interfere with any proper or lawful efforts by the IRS to obtain information. Promptly advise the client of any noncompliance and the consequences of such noncompliance if the Registered Tax Return Preparer knows the client has not complied with any tax law. Request for Information Not in Possession If requested records or information are not in the tax preparer s possession or are outside his or her control, the tax preparer must promptly notify the IRS. Any available information regarding the identity of the person possessing the records or information must be provided to the IRS. Tax preparers are required, if necessary, to ask the taxpayer about the identity of any person who may have possession or control of the requested records and information. The tax preparer is not required to expand the inquiry about the records and information beyond the taxpayer. mexample: Carolyn is an Enrolled Agent who works in a tax office that is open all year. In June, she received a letter from the IRS, in which she was instructed to provide all information and documents in her possession regarding Veil Corporation. Peter and Jan, clients for whom she prepares personal income tax returns only, own a controlling interest in Veil. Carolyn has no information or documents pertaining to Veil and does not know of any individual who may be in possession or control of the information. However, because Peter and Jan own a controlling interest in Veil, she is required to ask them if they have, or know who has, any documents or information that pertain to Veil Corporation.m

107 Ethics 18.9 Tax Tip: Generally, requests from the IRS are sent directly to the taxpayer rather than to the tax preparer. Thus, the tax preparer will not know of the request unless the client brings it to their attention. Complete Exercise 18.3 before continuing to read. COMPLIANCE It is generally understood that taxpayers must comply with the revenue laws of the United States by filing accurate and complete tax returns and related documents. Circular 230 provides guidance regarding a tax preparer s responsibilities when they have knowledge that a client has not complied with the Tax Code: Knowledge of client s omission. A practitioner who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return, document, affidavit, or other paper which the client submitted or executed under the revenue laws of the United States, must advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission. Noncompliance issues include: Refusing to provide records and information lawfully requested by the IRS. Reporting inaccurate income. Claiming deductions or credits for which the taxpayer does not qualify. When a tax preparer has knowledge that a client has not complied with any tax law, they must: Advise the client promptly of the fact of the noncompliance, error, or omission. Advise the client of the consequences of such noncompliance, error, or omission. The tax preparer s duty is complete upon informing the client of the noncompliance and the consequences of such actions. The tax preparer should not voluntarily inform the IRS of a client s noncompliance. In fact, doing so is a breach of confidentiality. If a client insists that the tax preparer prepare an inaccurate or incomplete tax return, the tax preparer must refuse to prepare the tax return.

108 18.10 H&R Block Income Tax Course (2016) mexample: Jennifer is a new client who has come in to have her return prepared. She is single, has a daughter, Ashley, and wants to file head of household. During the client interview, the tax preparer asks Jennifer about others who live in the household, and discovers that Jennifer s husband lived in the household during December, in the year previous to the tax year for which the tax preparer is preparing the return. Jennifer brought in last year s return, so the tax preparer knows that she filed as head of household and claimed EITC for that year. After asking a few more questions, it is clear that Jennifer thought that as long as her husband did not live with her for most of the year, she did not have to file a joint return with him. It is now the tax preparer s responsibility to inform Jennifer that she did not qualify to file as head of household for that tax year. The tax preparer must inform her of her obligation to amend the return, and the consequences for not doing so.m Benefits of Compliance A working environment that includes ethical standards provides different benefits to taxpayers and to tax preparers. Benefits of Compliance for Taxpayers Provides an accurate return, including all tax benefits to which they are entitled. Reduces the risk of the IRS questioning their returns. Increases their defense of all positions claimed. Minimizes the risk of being subject to noncompliance penalties. Benefits of Compliance for Tax Preparers Promotes taxpayer retention by providing a quality product. Lessens the risk of being called for an IRS preparer audit. Increases their defense of all positions advised. Minimizes the risk of being subject to preparer penalties. Shows integrity in the return preparation process. Risks of Noncompliance The risks of noncompliance vary, from monetary penalties to loss of tax or business privileges. Different penalties are charged to the taxpayers and to the tax preparer. Risks for Taxpayers Civil penalties with the possibility of incarceration for criminal penalties. Loss of EITC privilege for: 2 years for intentional or reckless disregard of EITC rules. 10 years for EITC fraud.

109 Risks for Tax Preparers IRS tax preparer audit or tax preparer EITC due diligence visit. Due diligence audits are conducted annually by the IRS. Selection is based on standard criteria applied to all EITC returns. Ethics Examination to check paid preparer compliance with all four EITC due diligence requirements. IRS will interview both the employee and employer. Criminal penalties with the possibility of incarceration. Civil penalties are strictly monetary penalties and are assessed for conduct not generally considered criminal in nature. Criminal penalties can be monetary, but may also involve prison time. This can happen when there is willful misconduct. Complete Exercise 18.4 before continuing to read.

110 18.12 H&R Block Income Tax Course (2016) DISREPUTABLE CONDUCT A tax preparer shall not commit any act of disreputable conduct. A tax preparer authorized to represent taxpayers may be disbarred or suspended from practice before the IRS for disreputable conduct. Any tax preparer may be forbidden from providing tax advice or preparing tax returns for other taxpayers. Examples of Disreputable Conduct Examples of disreputable conduct include the following: Committing any criminal offense under the revenue laws or committing any offense involving dishonesty or breach of trust. Knowingly giving false or misleading information in connection with federal tax matters or participating in such activity. Soliciting employment by prohibited means as discussed in Circular 230, Willfully failing to file a tax return, evading or attempting to evade any federal tax or payment, or participating in such actions. Misappropriating or failing to properly and promptly remit funds received from clients for payment of taxes. Directly or indirectly attempting to influence the official action of IRS employees by the use of threats, false accusations, duress, or coercion, or by offering gifts, favors, or any special inducements. Being disbarred or suspended from practice as an attorney, CPA, public accountant, or actuary by the District of Columbia or any state, possession, territory, or commonwealth, or any federal court, or any body or board of any federal agency. Knowingly aiding and abetting another person to practice before the IRS during a period of suspension, disbarment, or ineligibility. Maintaining a partnership to allow a disbarred person to continue practice before the IRS is presumed to be a violation.

111 Ethics Using abusive language, making false accusations and statements known to be false, circulating or publishing malicious or libelous matter, or engaging in any contemptuous conduct in connection with practice before the IRS. Giving a false opinion knowingly, recklessly, or through gross incompetence or following a pattern of providing incompetent opinions in questions arising under the federal laws. Tax Tip: Tax preparers who fail to comply with the EIC rules and regulations may incur EIC Due Diligence penalties of $505 per return for each violation. According to the H&R Block Code of Business Ethics, Tax Professionals who receive an IRS letter indicating that they have committed a paid preparer violation should notify their supervisor or District General Manager immediately. Sanctions Related to Disreputable Conduct Penalties for a tax preparer s disreputable conduct can be severe, including possible censure, suspension, or disbarment from practice before the IRS. Tax preparers may be prohibited from providing tax advice or preparing tax returns for any other taxpayers. More egregious behavior could result in high monetary penalties and even imprisonment. Penalties may be imposed, after a hearing, if a tax preparer: Is shown to be incompetent or disreputable. Fails to comply with any U.S. tax law or regulation. Willfully and knowingly misleads or threatens a client or prospective client with intent to defraud. Penalty of $5,000 or 50% (whichever is greater) of the income derived by the preparer if the tax preparer: Willfully understates a client s tax liability. Recklessly or intentionally disregards a U.S. tax law or regulation. Penalty of $1,000 or 50% (whichever is greater) of the income derived by the preparer if the tax preparer: Understates a client s tax liability due to a position that does not have a realistic possibility of being sustained and was not disclosed on the return or is determined to be frivolous. Terminology Understating a client s tax liability means: Understating the net tax liability. Overstating the net amount creditable or refundable. Frivolous position is one that is patently (obviously) improper.

112 18.14 H&R Block Income Tax Course (2016) BEST PRACTICES A tax return preparer is a person who prepares a return or claim for refund (or a substantial part of a return or claim for refund) for compensation, as well as a person who employs others to prepare all or a substantial part of a return. Signing tax return preparer. The individual tax return preparer that has the primary responsibility for the overall substantive accuracy of the preparation of the return or claim for refund. Nonsigning tax return preparer. Any tax return preparer who is not a signing tax return preparer but who prepares all or a substantial portion of a return or claim for refund with respect to events that have occurred at the time the advice is rendered. Defining Substantial Portion Whether a schedule, entry, or other portion of a return or claim for refund is a substantial portion is determined based upon whether the person knows or reasonably should know that the tax attributable to the schedule, entry, or other portion of a return or claim for refund is a substantial portion of the tax required to be shown on the return or claim for refund. A person who gives tax advice on a position that is directly relevant to the determination of the existence, characterization, or amount of an entry on a return or claim for refund will be regarded as having prepared that entry. Factors the IRS will consider in determining whether a schedule, entry, or other portion of a return or claim for refund is a substantial portion include: The size and complexity of the item relative to the taxpayer s gross income. The size of the understatement attributable to the item compared to the taxpayer s reported tax liability. Tax Tip: Caution: A single tax entry may constitute a substantial portion of the tax required to be shown on a return. De Minimis Rule for Nonsigning Preparers For purposes of determining whether a nonsigning preparer has prepared a substantial portion of a return, the schedule or other portion is not considered to be a substantial portion if the schedule, entry, or other portion of the return or claim for refund involves amounts of gross income, amounts of deductions, or amounts on the basis of which credits are determined that are: Less than $10,000. Less than $400,000 and also less than 20% of the gross income as shown on the return or claim for refund (or for an individual, the individual s AGI).

113 Ethics If more than one schedule, entry, or other portion is involved, all the schedules, entries, or other portions will be aggregated to apply this rule. mexample: A tax preparer prepares Schedule B (Form 1040) for an individual taxpayer, reporting $4,000 in dividend income. At the same time, the tax preparer also gives oral advice about Schedule A, which results in a claim of a medical expense deduction totaling $5,000. The tax preparer is not a nonsigning tax return preparer because the total aggregate amount of the deductions on Schedule A is less than $10,000. However, if the medical expense deduction totaled $15,000 and the taxpayer s AGI is $50,000, the tax preparer would be a nonsigning tax return preparer.m Preparing a Return that Affects Entries on Another Return If an entry or entries reported on one return (the first return ) affect an entry reported on another return (the second return ), the preparer of the first return is a nonsigning preparer of the second return if the entry or entries reported on the first return are directly reflected on the second return and constitute a substantial portion of the second return. mexample: A tax preparer who is the preparer of a partnership return is considered a tax return preparer of each partner s individual tax return if the entry or entries on the partnership return that are reportable on each partner s individual tax return(s) constitute a substantial portion of that return.m One Preparer Per Position Rule A tax return preparer is subject to a 6694 penalty if the individual is primarily responsible for a position on the return or claim for refund giving rise to an understatement. The preparer is subject to the penalty if all the following are true: 1. There was no substantial authority for the position. 2. The preparer knew (or reasonably should have known) of the position. 3. Either the position wasn t disclosed or there was no reasonable basis for the position. Under the final regulations, there is only one person within a firm who will be considered primarily responsible for each position giving rise to an understatement and thus subject to a 6694 penalty (a change from the previous regulation, where the rule was that there was one preparer subject to penalty per firm the signing preparer). Identifying the Individual Who is Primarily Responsible for the Position If there is a signing return preparer within the firm, the signing tax return preparer will be considered the person who is primarily responsible for all the positions on the return or claim for refund giving rise to the understatement. However, if the IRS receives credible information from any source, it can conclude, on the basis of that information, that a nonsigning tax return preparer is primarily responsible for the position(s) giving rise to an understatement. In that case, a nonsigning tax return preparer within the signing tax return preparer s firm will be considered the tax return preparer that is primarily responsible for the position(s) on the return. If the information supports the conclusion that either the signing tax return preparer or a nonsigning tax return preparer is primarily responsible for the position giving rise to the understatement, the penalty may be assessed against either of the individuals, but not both.

114 18.16 H&R Block Income Tax Course (2016) Preparer Tip: Because the IRS will look at credible information to determine who is responsible for the position in question, it is necessary for preparers to contemporaneously document advice given and received, and retain that documentation. Advisors should document what information the signing preparer gave them, what advice was asked for and the date, as well as the response they gave and the date. Even though there is a one-preparer-per-position rule, it is still true that the firm that employs the preparer, as well as the individual preparer, may both be subject to penalty with respect to the same position(s) if certain conditions are met. And under the final regulations, it is possible that there may be more than one preparer of the same return within a single firm (for example, a signing preparer and a nonsigning preparer) who may be subject to penalties, if they were each primarily responsible for different positions. Substantial Authority An unreasonable position does not meet the substantial authority standard. The substantial authority standard is an objective standard involving an analysis of the law and application of the law to the relevant facts. For this purpose, all authorities relevant to the tax treatment of an item, including the authorities contrary to the treatment, are taken into account in determining whether substantial authority exists. The weight accorded an authority depends on its relevance and persuasiveness, and the type of document providing the authority. Authorities Used to Determine if Substantial Authority or Reasonable Basis Exists. Reg (d)3(iii) Provisions of the Internal Revenue Code and other statutory provisions. Regulations (proposed, temporary, and final) construing such statutes. Revenue rulings and revenue procedures. Tax treaties regulations thereunder, and Treasury Department and other official explanations of such treaties. Court cases. Congressional intent as reflected in committee reports, joint explanatory statements of managers included in conference committee reports, and floor statements made prior to enactment by one of the bill s managers. General explanations of tax legislation prepared by the Joint Committee on Taxation (the Blue Book). Private letter rulings and technical advice memoranda issued after October 31, Actions on decisions and general counsel memoranda issued after March 12, 1981 (as well as general counsel memoranda published in pre-1955 volumes of the Cumulative Bulletin). Internal Revenue Service information or press releases. Notices, announcements and other administrative pronouncements published by the Service in the Internal Revenue Bulletin.

115 Illustration 18.2 Ethics 18.17

116 18.18 H&R Block Income Tax Course (2016) DISCLOSURE Form 8275, Disclosure Statement, shown in Illustration 18.2 on the next page, is filed to disclose items or positions that are not otherwise disclosed on a tax return. Accuracy-related penalties can be avoided if the return position has a reasonable basis. Accuracy-related penalties attributable to the following types of misconduct cannot be avoided by disclosure on Form 8275: Negligence. Disregard of regulations. Any substantial understatement of income tax on a tax shelter item. Any substantial valuation misstatement. Any substantial overstatement of pension liabilities. Any substantial estate or gift tax valuation understatements. ELECTRONIC FILING An Electronic Return Originator (ERO) is an authorized IRS e-file provider that originates the electronic submission of tax returns to the IRS. H&R Block is an ERO, as well as a tax return preparer. The IRS considers that confirmation of individual taxpayer identification numbers is critical in preventing taxpayer fraud. Tax preparers, whether operating independently or as part of a tax preparation company, play a key role in preventing taxpayer fraud. EROs are tasked with the responsibility of ensuring that all taxpayer identification numbers (TIN) are transcribed correctly from source documents to the electronic filing. Tax Tip: The most common reasons e-filed returns are rejected: Use of an incorrect TIN on a tax return. Mismatches between name and TIN. The same TIN on more than one return. Verifying Taxpayer Identification Numbers EROs must confirm the identities and taxpayer identification numbers (TINs) of taxpayers, spouses, and dependents listed on returns. Ask clients for their TIN cards to avoid including incorrect numbers for taxpayers, spouses, and dependents on tax returns. Tax preparers should ask clients not known to them to provide two forms of identification that include their name and current address. Picture IDs are preferable.

117 Nonstandard Information Documents Ethics Tax preparers must never alter or advise a taxpayer to alter any information on Forms W-2, W-2G, 1099-R, or any other documents. If a taxpayer submits Forms W-2, W-2G, or 1099-R in which the taxpayer s SSN, name, or address have been altered, question the taxpayer to be sure the TIN, name, and address reported on Form 1040 are all correct and document how this determination was made. Then: Enter nonstandard form code on the e-file submission. See Illustration 18.3, below. Inform the taxpayer that the IRS will later send them a notice that the information on the return does not match the information they have previously received from an employer or other sources. The IRS notice will request additional or updated information. Illustration 18.3 For any other changes, the taxpayer should request a corrected W-2 from the employer. If the employer does not honor the request, the tax preparer should prepare a substitute Form W-2, using the information from the taxpayer s most reliable records. Tax preparers Should be Alert for Suspicious or Altered Forms An ERO or tax preparer who observes or becomes aware of suspicious activity concerning the filing of tax returns or potentially abusive returns should report it to the IRS. For additional information about e-file requirements, see IRS Publication 1345 and Revenue Procedure Income tax returns may be prepared using other documentation of income and federal tax withholding, such as pay stubs and leave and earnings statements. However, returns prepared based on these nonstandard documents must not be electronically filed prior to the ERO s receipt of the related Form W-2, W-2G, or 1099-R. If the taxpayer is unable to provide a correct Form W-2, W-2G, or 1099-R, the return may be filed after February 14, and after completing Form 4852 (substitute W-2). When Form 4852 is used, the nonstandard indicator must be included in the e-file record, and the Form 4852 must be retained in the same manner as Forms W-2, W-2G, and 1099-R. Negotiating Checks is Forbidden A tax preparer is forbidden to endorse or otherwise negotiate any check issued to a client by the government in respect of a federal tax liability. mexample: Paul operates a tax preparation business in an economically disadvantaged part of town. Many of his clients do not have banking relationships. They have to pay high fees to cash checks. Last year, Paul ran a promotion in which he offered to cash federal refund checks for no charge for clients who paid to have him prepare their federal and state tax returns.

118 18.20 H&R Block Income Tax Course (2016) Paul should quickly change his promotional offer. As a tax preparer, Paul cannot cash federal income tax refund checks for his clients or anyone else. This prohibition applies regardless of whether Paul is authorized to represent taxpayers or is an unenrolled preparer.m Return Preparation Issues Tax preparers are required to complete all of the following actions: Sign the tax return, and enter their preparer tax identification number (PTIN) in the space provided on the return, after it has been completed and before it is presented to the taxpayer. Enter the business address in the space provided on the return. Furnish the taxpayer with a completed copy of the return at the time the return is presented for the taxpayer s signature. Retain one of the following for a period of three years after the close of the return period: A copy of the taxpayer s completed return. A record of the name, TIN, taxable year of the taxpayer, and type of return prepared. In this chapter, you learned to: Define due diligence. CHAPTER SUMMARY Identify scenarios that present a conflict of interest. State key requirements of client confidentiality. Identify situations of noncompliance and respond appropriately. Perform best practices that fulfill ethical requirements. Ethical behavior is a positive choice. Tax preparers must always strive to conduct their business relationships to the highest ethical standard. Suggested Reading For further information on the topics discussed in this chapter, you may wish to read IRS Publication 470, Limited Practice Without Enrollment, or Circular 230, Regulations Governing Practice before the Internal Revenue Service.

119 Ethics The Tax Institute Tax in the News Research Question: A client had health insurance coverage through her employer for all of Her husband lost coverage at the end of 2014 when he left his job and he has not obtained any other coverage since then. Her 2015 income is significantly higher than his about $75,000 for her versus about $15,000 from various temporary jobs for him. The ACA penalty on their joint return is over $1,300. There are no exceptions that apply. However, the penalty is much lower ($325) if we take only his income into account. If we file a separate return for him, can we disregard her income for the penalty calculation and, if so, is it recommended to do so? Is there a way to exclude her income from the penalty calculation but still have them file a joint return? Answer: If you file a separate return for the husband, you would include only his own income in MAGI for the penalty calculation. As for whether you should do so, it is best to run the numbers both ways to make sure the advantage of the penalty reduction is not offset by higher taxes that result from filing two separate returns. For your last question, no, it is not possible to consider only the MAGI of the uninsured spouse just for the ACA penalty calculation but otherwise get all the advantages of filing a joint return. Here are some points to consider when deciding whether to file separate returns for a married couple in order to reduce the penalty: The penalty calculation itself. The minimum annual penalty for one uninsured adult in 2015 is $325 and that is the penalty the uninsured husband would pay on an MFS return in this situation. Depending on the relative and total incomes of the two spouses, it could be that the penalty on a joint return is the same or not much higher than on a separate return, or that an uninsured spouse would pay an even higher penalty on a separate return. The MFS tax calculation. The tax calculation for a married taxpayer filing a separate return is usually the least favorable calculation. The extra tax the higher income spouse would pay on an MFS return could more than eclipse the lower penalty the lower earning spouse would pay on a separate return. Itemized deductions. For a couple that would ordinarily itemize deductions, decisions have to be made about how the spouses will split the deductions on their separate returns. If the higher earning spouse claims most of the deductions in order to minimize her taxes, the lower earning spouse could be left with nothing to deduct. Children. The couple would also need to consider which one of them will claim exemptions for children or other dependents. Again, if the higher earning spouse claims all of the exemptions the lower earning spouse could be at a disadvantage. Also, dependent related tax credits may be reduced or disallowed altogether if they file MFS.

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121 22 19 State Tax Final Fundamentals Exam I OVERVIEW This entire session will be devoted to state tax theory. Please refer to the State Tax participant s guide you received with your course materials. 19.1

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123 22 20 State Tax Final Fundamentals Exam II OVERVIEW This entire session will be devoted to state tax theory. Please refer to the State Tax participant s guide you received with your course materials. 20.1

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125 21 Final Test Review OVERVIEW This entire session is devoted to a review of the class to help you prepare for the Final Test. Your instructor will lead the review and use various questions and scenarios to help you prepare. You will also be expected to complete two tax returns in this review using BlockWorks. The returns are comprehensive returns, incorporating many of the concepts you have learned. The review returns are not intended to replicate the tax returns on the Final Test. You will have time available to ask any questions you may have. However, this will not be a session where participant questions dominate the entire time period. Similar to the Midterm Test, the Final Test will consist of three parts: Part I Ten questions for you to determine a taxpayer s: Correct and most favorable 2015 filing status. Greatest number of personal and dependent exemptions. Eligibility to claim the Earned Income Credit. Part II Ten multiple-choice questions which may cover any material presented in the course. Part III Two tax returns completed using BlockWorks and then specific information from these returns are entered into the online test. INSTRUCTIONS Your instructor has review questions that may be used to review topics covered during the class. You will also be given time to complete two tax returns and discuss the results in class. The returns should be completed in class using BlockWorks. You will also be given an opportunity to ask questions on any subjects about which you need more clarity after having reviewed for the final. The final is open-book, and you may also use any notes you have taken during the class. You may find it helpful to have a copy of the Tax Season 2016 Desk Card and copies of 2015 Forms 1040EZ and 1040A where they are readily available for viewing. The Desk Card can be found in the Appendix on page A.24. You can see copies of Forms 1040EZ and 1040A in Chapter 1, beginning on page

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127 22 Final Exam Test OVERVIEW This entire session will be devoted to the Final Test. The test will consist of three parts: Part I Ten questions for you to determine a taxpayer s: Correct and most favorable 2015 filing status. Greatest number of personal and dependent exemptions. Eligibility to claim the Earned Income Tax Credit. Part II Ten multiple choice questions which may cover any material presented in the course, plus an additional three questions on Ethics. Part III Two final tax returns completed using BlockWorks, from which specific information will be entered into the online test. INSTRUCTIONS To complete the Final Test, you should do the tax returns using BlockWorks. Your instructor will give you directions about completing the return. Once you complete the return to your satisfaction, enter the online site, as directed by your instructor, and follow the on-screen directions to complete your Final Test. When you access the site, Part I of the test will appear. Answer those questions and then you will see Part II. After entering the answers for both Part I and Part II, Part III will appear. Use the information from the returns you just completed and enter the requested information. The final is open-book, and you may also use any notes you have taken during the class. You may find it helpful to have a copy of the Tax Season 2016 Desk Card and copies of 2015 Forms 1040EZ and 1040A where they are readily available for viewing. The Desk Card can be found in the appendix on page A.24. You can see copies of Forms 1040EZ and 1040A in Chapter 1, beginning on page

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129 A Appendix TABLE OF CONTENTS ITEM OR TOPIC 2015 Tax Rate Schedules A Tax Computation Worksheet A Tax Table A Earned Income Credit (EIC) Table A.17 Desk Card A.24 Poster Tax Computation Process A.27 Poster Filing Status A.29 Poster A Dependent Is... A.31 Compliance A.33 Conversations A.35 Client Experience A.36 Interviewing the Client A.37 BlockWorks Hot Keys and Symbols A.41 PAGE A.1

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131 Illustration X.X Appendix A.3

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135 Appendix A.7

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137 Appendix A.9

138 A.10 H&R Block Income Tax Course (2016)

139 Appendix A.11

140 A.12 H&R Block Income Tax Course (2016)

141 Appendix A.13

142 A.14 H&R Block Income Tax Course (2016)

143 Appendix A.15

144 A.16 H&R Block Income Tax Course (2016)

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146 A.18 H&R Block Income Tax Course (2016)

147 Appendix A.19

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149 Appendix A.21

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153 Appendix A.25

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161 Appendix A.33 COMPLIANCE IRS Changes Every year, the IRS conducts audits of offices and Tax Professionals. These may be random audits or the result of a complaint. Cases may be forwarded to the Criminal Investigation division for possible prosecution or fines, and penalties may be assessed against the Tax Professional and/or the Company. As a Tax Professional, you can help to manage the risk to the Company, to your office, and to yourself. Managing Risk Managing risk involves verifying paperwork and information. You should verify client information on documents such as: Income information worksheets. Forms 8453/8879. Form Ensure client understanding of filing status, dependents, income, and deductions. Other issues to clarify and check include: Business losses. Rental property losses. Child care credits. EIC returns. Schedules A/C characteristics that manage to sweeten the pot. Income sources, such as daycare and cleaning services. Schedules A/C with round dollar amounts. Schedule A with no mortgage, but high deductions that include non-documented items. None of these are definitive indicators of misrepresentation or falsification, but they may cause increased scrutiny by the IRS and raise questions regarding our responsibility to file an accurate return. Record your efforts to obtain appropriate documentation and exercise due diligence by recording those efforts in BlockWorks. These notes protect you and H&R Block. Handling Clients Before clients sign and submit their returns, encourage them to review the return in its entirety. In high-risk cases, such as those listed above, you should advise your client, This may expose your return to a higher degree of scrutiny by the IRS. Without excellent documentation, this could be challenged. If you know the client is not providing accurate information or does not have the documentation required to verify any claim, you have the right to refuse to complete the return until accurate information is provided, and you should refuse to prepare such a return.

162 A.34 H&R Block Income Tax Course (2016) Do not, under any circumstances, accuse a client of attempting to defraud the IRS. Instead, focus on the client s lack of documentation. Indicate that when the client is able to provide accurate and sufficient documentation to support the claim, you will be glad to complete the return. Until the documentation is supplied, you should not file the return. Privacy and Confidentiality According to the FBI, identity theft is the fastest growing crime in the United States today. As of 2015, only three states have not enacted legislation regarding the notification of clients if their personal information is exposed due to computer theft, hacking, or other security breach. Safeguarding clients and associates personal information is a high priority, and failure to do so is a violation of law. Whether the data is maintained on paper or electronically, you should take every precaution to protect the information from loss, misuse, and unauthorized access, disclosure, alteration, and destruction. Remember to point to numbers, rather than saying them aloud whenever possible. Speak low enough that others sitting around your desk cannot overhear clients sensitive information. Explain why you need the information you ask for. Ensure that client information is not on your desk, and is securely stored. Immediately retrieve items from the printer. Verify that all documents that you provide to the client belong to that client. All clients should be advised that any documents not used are shredded, and documents that remain at the office are stored in a secure location. Section 7216 of the Internal Revenue Code Section 7216 generally requires that you obtain the client s written consent before using their information for purposes other than preparing their return or before you may share their tax return information with affiliates or third parties. There are certain exceptions to this rule, but if you have any questions, you should seek legal advice. The Gramm-Leach-Bliley Act (GLB) Gramm-Leach-Bliley (GLB) is another privacy law that applies to tax return preparers. Under GLB, you must provide, at least on an annual basis, clear and conspicuous notice of H&R Block s policies and procedures for protecting customers nonpublic personally identifiable information ( NPI ). The Gramm-Leach-Bliley Act of 1999, also known as the Financial Services Modernization Act, is the umbrella for several consumer financial privacy issues that apply to H&R Block. First, GLB requires us to: Disclose to clients the types of information we collect about them. Disclose to clients our information-sharing practices. Permit clients to decide, by opt-out or opt-in, whether or not we may share information with third parties. Second, GLB requires us to be aggressive in safeguarding clients personal information: Manage the physical security of our offices, computers, and client records to minimize vulnerability to information theft and unauthorized access to, or disclosure of, personal client information. Manage the security and integrity of our computer systems to prevent unauthorized access and protect the data processed and stored by these systems.

163 Appendix A.35 CONVERSATIONS Listening Listening as a method of taking in information is used far more than reading and writing combined, yet is the least understood function of all. When we think about listening, we tend to assume it is basically the same as hearing. As a result, we make little effort to learn or develop listening skills. Listening involves a more sophisticated mental process than hearing, demanding energy and discipline. Listening is an active, rather than passive, process. Listening is: Taking in information from the client while remaining nonjudgmental and empathetic. Acknowledging the client in a way that invites communication to continue. Providing limited, but encouraging, input to the client s response. Carrying the client s idea one step forward. As a listener, you have a responsibility in the communication process for moving your relationship with the client forward. Listening occurs on three levels: Spurts. Hearing sounds and words. Active listening. LEVELS Level 3 Level 2 Level 1 DESCRIPTION Listening in spurts: tuning in and tuning out to the voices around you, being aware of others but mainly paying attention to yourself. Halflistening: following the discussion long enough to get your chance to talk. Passive listening: listening but not responding, faking attention, preparing for your turn to speak. Hearing sounds and words, but not really listening: staying at the surface of communication, not paying attention to the deeper meaning of what s being said. Hearing what the client is saying, but not making an effort to understand the intent. Active listening: not evaluating the words, looking at things from the client s point of view. Acknowledging and responding. Being empathetic to the client s feelings and thoughts.

164 A.36 H&R Block Income Tax Course (2016) To improve your skills at listening to clients: Find areas of common interest. Take the initiative to find out what the client knows. Focus your attention on the client s central ideas in the conversation. Make meaningful notes. Hold your response until you have listened to the client s full point. Ask questions to clarify for understanding. Summarize the client s statement back to them to ensure full understanding. Focus on the content of the statement rather than the delivery style. CLIENT EXPERIENCE Tax Interview It is vital that your tax interview engages clients in a dialogue. Clients do not want to be questioned or interrogated. They want to work with you to achieve the best possible result. During the tax interview, your clients will be sharing personal information. It is important that your language, behavior, and attitude demonstrate respect and empathy. The client experience protocol for the tax interview helps clients feel secure and builds confidence: Engage the clients throughout, explaining what you are doing and why. Give clients the opportunity to ask questions. Maintain confidentiality and privacy of all client information. Demonstrate your proficiency with our tax preparation software while you focus on the clients. Educate the clients, providing relevant and actionable advice. Orient the clients to where you are in the process and what remains to be done.

165 Appendix A.37 INTERVIEWING THE CLIENT Overview The way you handle questions asking and answering them sets the atmosphere of professionalism and competency. Types of Questions Several types of questions can be used during your interview, each with appropriate and inappropriate use. Some question types are: TYPE AND DEFINITION Open Clients are expected to volunteer the answer. How soon do you want your refund? Closed Yes or no answers. Did you pay any student loan interest this year? Rhetorical No answer is expected. What client doesn t want to claim every allowable credit? Avoid using questions that might embarrass clients. Posing Questions APPROPRIATE USE Keep clients alert, involved, and thinking. Bring an uninvolved client back into the conversation. Prompted by BlockWorks. Guide the conversation to another topic. Compel clients to think, but not reply, when an answer is not required. Many times a good question may be poorly delivered, causing confusion. The following are common mistakes that new Tax Professionals make when asking questions. Pitfalls and Poor Questions Asking questions only one way, followed by a long pause. Answering too quickly when asked a question. Stating rather than asking no inflection at the end of a question. Asking a question with an obvious answer in mind.

166 A.38 H&R Block Income Tax Course (2016) How to Ask Effective Questions 1. Pause slightly to attract attention. 2. Ask the question and: Make eye contact with the client. Lift your voice at the end. 3. Pause until you get a reply. 4. Rephrase the question to clarify or suggest the type of answer you desire. 5. Wait for the answer and respond. Handling Questions and Answers Client questions are where the interview meets the real world where the focus shifts from theoretical to actual. Before the Interview Anticipate questions and prepare answers. Prepare an answer and rehearse the delivery. During the Interview Repeat or rephrase the question for clarity. Thank the client for asking a good question. Answer the question and check for understanding. If You Do Not Know the Answer Repeat the question (verbatim or paraphrased). It gives you time to formulate the correct answer. Ask for the question to be repeated (sometimes the clients make it clearer). Don t bluff admit that you don t know but will find out. Remember that no one Tax Professional knows all of the answers. The legal code for taxes is immense, but you also have an immense volume of references available to you. Your desktop has the catalog of IRS Publications, BlockWorks has help files, and you have an office full of other Tax Professionals you can ask.

167 Discussion Can Get Out of Hand Appendix A.39 Discussion is absolutely essential. It is a chance for your clients to clarify what they think they heard, associate it with what they already know, and begin thinking about how they can apply it. It is also a chance for you to establish a conversation with your clients, rather than just a one-way information feed. However, too much discussion can result in: Getting off subject. Running a subject into the ground. Allowing one or two clients to dominate your time, angering your other appointments. Rushing because you are behind time. Avoid Getting Sidetracked Here s how to redirect the energy without losing the dynamic. STEP ACTION EXAMPLE 1. Validate the current digression. Steve, that s an interesting point you make. 2. Tease forward to a pertinent section. In fact, we ll be discussing options to get your refund to you in a little while. 3. Empower the client. That is a good point and I will be discussing this with you in more detail later in the interview. Let me make myself a note to remind me later to discuss this with you. 4. Redirect to the topic. Steve, didn t I hear you mention something about going back to school? Let s see if you qualify for an education credit.

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169 Appendix A.41

170 A.42 H&R Block Income Tax Course (2016)