CHAPTER 8

INDIVIDUAL INCOME TAX

COMPUTATION AND TAX
CREDITS

Taxpayers Regular Tax

Liability

Regular tax computation dependent

upon:
Filing status

Married filing jointly

Qualifying widow or widower (also called Surviving
spouse)
Married filing separately
Head of household
Single

Progressive tax rates

Tax rate schedules - all tax rate schedules consist of
tax brackets taxed at 10 percent, 15 percent, 25
percent, 28 percent, 33 percent, 35 percent and 39.6
percent.
Tax tables

Marriage penalty or benefit

Who is likely to have penalty?
Both spouses receive income
Who is likely to have benefit?
One spouse receives income

The marriage penalty applies to

couples with two wage earners
while a marriage benefit applies to
couples with single breadwinners.

MARRIAGE PENALTY
A marriage penalty (benefit) occurs when,
for a given level of income, a married
couple has a greater (lesser) tax liability
when they use the married filing jointly tax
rate schedule to determine the tax on their
joint income than they would have owed (in
total) if each spouse would have used the
single tax rate schedule to compute the tax
on each spouses individual income.
The marriage penalty applies to couples
with two wage earners while a marriage
benefit applies to couples with single
breadwinners.

Marriage Penalty (Benefit) Two Income

vs. Single Income Married Couple

Computing The Tax

Taxpayers compute the tax on the ordinary income
portion by applying the appropriate tax rate
schedule (based on their filing status).
Taxpayers generally compute their tax on the
preferentially taxed income by multiplying the
amount of income by 15%. However, to the extent
that it would have been taxed at a rate of 15% or
l0% if it were ordinary income, the preferentially
taxed income (dividends and long-term capital
gains) is taxed at 0% in 2015.
20% preferential tax if income is taxed at 39.6%

A taxpayers total regular income tax liability is the

sum of the tax on ordinary income and the tax on
preferentially taxed income.

Federal Income Tax Computation

Exceptions to ordinary tax rates
Long-term capital gains (net capital gains)
Generally 0%,15%, or 20%, but can be as high as
28%
Two different tax rates on one gain is possible

Dividends
Qualified dividends generally taxed at 0%,15%,
or 20%
Two different tax rates on one dividend is possible

7-7

Exceptions to Ordinary Tax

Rates
A capital gain is the gain recognized on the disposition
of a capital asset.
A capital asset is any asset other than:
Accounts receivable from the sale of goods or
services.
Inventory and other assets held for sale in the
ordinary course of business.
Assets used in a trade or business, including
supplies.

Long-term capital gains (net capital gains)

Generally 15% but can be as high as 28% or as
low as 0%
Two different tax rates on one gain is possible
Only net long-term capital gains in excess of
net short-term capital losses are taxed at
preferential rates.

DIVIDENDS - Exceptions to
Ordinary Tax Rates

Qualified dividends generally taxed at 15% or 20% if

income is taxed at 39.6% but could be taxed as low as
0%.
Two different tax rates on one dividend is possible
Qualified dividends generally include dividends paid
by a U.S. corporation (including mutual funds) on stock
that the taxpayer has held for a certain amount of
time.
Preferentially taxed income must be computed separately
from tax rate tables and tax rate schedules.
Step 1: Split taxable income into the portion that is subject to
the preferential rate and the portion taxed at the ordinary
rates.
Step 2: Compute the tax separately on each type of income.
Note that the income that is not taxed at the preferential rate
is taxed at the ordinary tax rates using the tax rate schedule
for the taxpayer's filing status.
Step 3: Add the tax on the income subject to the preferential
tax rates and the tax on the income subject to the ordinary
rates. This is the taxpayer's regular tax liability.

If the preferentially taxed income would have

been taxed at 10% or 15% if it were ordinary
income, it is taxed at a lower 0% rate.
If it would have been
than 15%, it is taxed at
would have been taxed
we refer to the income
income.

taxed at a rate higher

15% or 20% if income
at 39.6%. This is why
as preferentially taxed

There are certain types of long-term capital

gains that are taxed at a maximum rate of 25%
(unrecaptured 1250 gain) and 28% (capital
gains from collectibles).

These gains are taxed at the taxpayers

marginal ordinary rate unless the ordinary rate

Tax Computation Example

Assume that Courtneys taxable
income is $449,000 including $15,000
of qualifying dividends taxed at the
preferential rate. What would be
Courtneys tax liability under these
circumstances?

7-11

Tax Computation Example

Solution

3.8 Percent Medicare

Contribution Tax

3.8 Percent Medicare Contribution Tax on Net Investment Income For years after 2012, a
3.8 percent Medicare contribution tax is imposed on net investment income. For purposes
of this tax, net investment income equals the sum of:
1. Gross income from interest, dividends, annuities, royalties, and rents (unless these items
are derived in a trade or business to which the Medicare contribution tax does not apply).
2. Income from a trade or business that is a passive activity (described in Chapter 11) or a
trade or business of trading financial instruments or commodities.
3. Net gain from disposing of property (other than property held in a trade or business in
which the Medicare contribution tax does not apply). 3

Less the allowable deductions that are allocable to items 1, 2, and 3.

Tax-exempt interest, veterans' benefits, excluded gain from the sale of a principal
residence, distributions from qualified retirement plans, and any amounts subject to selfemployment tax are not subject to the Medicare contribution tax.

The tax imposed is 3.8 percent of the lesser of (1) net investment income or (2) the excess
of modified adjusted gross income over $250,000 for married-joint filers and surviving
spouses, $125,000 for married separate filers, and $200,000 for other taxpayers. Modified
adjusted gross income equals adjusted gross income increased by income excluded under
the foreign earned income exclusion less any disallowed deductions associated with the
foreign earned income exclusion

Net Investment IncomeTax

3.8% tax imposed on lesser of:
Net investment income (e.g., interest,
dividends, annuities, royalties, rents,
passive activity income, net gains from
disposing of property, less related
allowed deductions) or
Excess of modified AGI over $250,000
(MFJ), $125,000 (MFS), and $200,000 (all
others)
14

KIDDIE TAX
A parent can shift unearned income to a child
by transferring actual ownership of the incomeproducing property to the child.
Earned income is income earned by the
taxpayer from services or labor. Unearned
income is from investment property such as
dividends from stocks or interest from bonds.
The kiddie tax is a tax at the parents marginal
rate on the childs unearned income in excess
of $2,100. Generally, the kiddie tax liability is
reported on the childs tax return. However,
the parents can make an election to include on
their own return the childs gross income in
excess of $2,100.

Federal Income Tax Computation

Kiddie tax
Net unearned income taxed at parents marginal rate
Net unearned income = unearned income in excess
of $2,100
Parents can elect to actually include this income on
their tax return.
Applies if
Child is under age 18 at year end,
Child is 18 at year end but earned income not
greater than half of childs support, or
Child is over age 18 but under age 24, is a full-time
student, and childs earned income not greater than
half of childs support.

7-16

KIDDIE TAX
If the kiddie tax applies, children must pay
tax on a certain amount of their net
unearned income, (unearned income in
excess of a specified threshold amount of a
child under the age of 19 or under the age
of 24 if a full-time student,) at their
parents' marginal tax rate rather than at
their own marginal tax rate, unless the
parents' marginal tax rate on the income
(the preferential tax rate if the income is
long-term
capital
gain
or
qualified
dividends) would be lower than the child's
marginal tax rate.

Though the kiddie tax significantly

limits the benefit of shifting income
producing assets to children, it does
not eliminate it.

The kiddie tax does not apply unless

the child has unearned investment
income in excess of $2,100 ($1,050
standard deduction plus an additional
$1,050).
Parents can shift up to $2,100 of
unearned investment income to a

The kiddie tax applies to children who have

net unearned income in excess of $2,100 if
the children:
(1) are under age 18 at the end of the
year,
(2) are age 18 at the end of the year and
do not have earned income in excess of
half of their support, or
(3) are over age 18 and under age 24, are
full-time students, and dont have earned
income in excess of half of their support
(excluding scholarships).
(4) The kiddie tax base is the childs net
unearned income. Net unearned income is
the childs gross unearned income minus

Kiddie Tax EXAMPLE

Suppose that during 2015, Deron received $1,100 in
interest from the IBM bond, and he received another
$2,200 in interest income from a money market
account that his parents have been contributing to
over the years. Is Deron potentially subject to the
kiddie tax?
Answer:Yes, Deron is younger than 18 years old at
the end of the year and his net unearned income
exceeds $2,100. He is potentially subject to the
kiddie tax.

What is Deron's taxable income and

corresponding tax liability? (Derons
mother Courtney is subject to a 25%
marginal tax rate.)

Kiddie Tax Example Solution

(contd)

7-21

Alternative Minimum Tax

Congress implemented the AMT to ensure
that all taxpayers who were generating
economic income paid some minimum
amount of tax each year.
Prior to the AMT, the public perceived high
income taxpayers to be able to reduce or
eliminate their total tax liability by taking
excessive advantage of tax preference items
such as exclusions, deferrals, and deductions.
The AMT was designed as a response
requiring these high income taxpayers to pay
at least some tax.

Alternative Minimum Tax

The AMT is designed to tax an income base that
more closely reflects economic income than does
the regular income tax system.
Many items that are deductible for AMT
purposes are not deductible for regular tax
purposes.
Certain types of income included in the AMT base
are not included in the regular income tax base.
AMT rates are different from those for the regular
income tax.
The starting point for computing the AMT tax
base is regular taxable income.
The AMT system allows certain deductions from
the income tax base.

ALTERNATIVE MINIMUM TAX

Exemptions and Standard Deductions added back

first:
- Personal and dependency exemptions
- Standard Deduction
Items commonly added back to regular taxable
income in computing AMT income:
State income taxes
Real property taxes
Home-equity loan interest expense (if proceeds
not used to improve home)
Miscellaneous itemized deductions in excess of 2%
floor
Taxpayers add back the standard deduction only if they
deducted it when computing their regular taxable income

COMMON AMT ADJUSTMENTS

Plus adjustments:
Tax-exempt interest from private activity bonds
Real property and personal property taxes deducted
as itemized deductions
State income or sales taxes
Home-equity interest expense
Miscellaneous itemized deductions (subject to the
2% floor) in excess of the 2% floor
Plus or Minus adjustment:
Depreciation
Minus adjustments:
State income tax refunds included in regular taxable
income
Gain or loss on sale of depreciable assets

Alternative Minimum Tax

Formula

7-26

Plus adjustments
Tax exempt interest from private
activity bonds

Description
Taxpayers must add back interest income that was excluded
for regular tax purposes if the bonds were used to fund private
activities (privately owned baseball stadium or private
business subsidies) and not the public good (build or repair
public roads). Interest from private activity bonds issued in
either 2009 or 2010 is not added back.

Real property and personal

property taxes deducted as
itemized deductions

Deductible for regular tax purposes but not for AMT purposes.

State income or sales taxes

Deductible for regular tax purposes but not for AMT purposes.

Home-equity interest expense

This is not deductible for AMT purposes if the proceeds from

the loan are used for purposes other than to acquire or
substantially improve the home.

Miscellaneous itemized
deductions (subject to the 2%
floor) in excess of the 2% floor.

Deductible for regular tax purposes but not for AMT purposes.

Plus or Minus adjustment:

Depreciation

Minus adjustments:
State income tax refunds included
in regular taxable income

Description
Taxpayers must compute their depreciation expense for AMT
purposes. For certain types of assets, the regular tax method is
more accelerated than the AMT method. In any event, if the
regular tax depreciation exceeds the AMT depreciation, this is
a plus adjustment. If the AMT depreciation exceeds the regular
tax depreciation, this is a minus adjustment.

Because state income taxes paid are not deductible for AMT
purposes, refunds are not taxable (they do not increase the
AMT base)

Gain or loss on sale of depreciable Due to differences in regular tax and AMT depreciation
assets
methods, taxpayers may have a different adjusted basis (cost
minus accumulated depreciation) for regular tax and for AMT
purposes. Thus, they may have a different gain or loss for
regular tax purposes than they do for AMT purposes. If regular
tax gain exceeds AMT gain, this is a minus adjustment.
Because AMT accumulated depreciation will never exceed
regular tax accumulated depreciation, this would never be a
plus adjustment.

Other AMT Adjustments

The major itemized deductions that are deductible for both regular
tax and AMT purposes using the same limitations are:
Casualty and theft losses.
Charitable contributions.
Home mortgage interest expenses.
Gambling losses.
Deductions that are deductible for regular tax and AMT purposes
but have different limitations are:

Medical expenses (10 percent of AGI floor for AMT purposes if

taxpayer is 65 or older).
Home-equity interest (interest not deductible unless loan proceeds
used to acquire or substantially improve the home).
Investment interest expense (interest income that is tax exempt
for regular tax purposes but included in the AMT base is included
in investment income for determining the AMT investment interest
expense deduction).

Alternative Minimum Tax

AMT is a tax based on an alternative more
inclusive tax base than regular taxable
income.
Meant to ensure that taxpayers are paying
some minimum level of tax.

Who is most likely to pay it and why?

High state taxes
Multiple children
Capital gains
7-31

Alternative Minimum Tax

Why is it so prevalent?
Individual tax rates have decreased since AMT
enacted

AMT rates 26% or 28% vs. individual

ordinary rates 10%, 15%, 25%, 28%, 33%,
35%, 39.6%

7-32

AMT Exemption
The AMT exemption ensures that low-income
taxpayers arent subject to the AMT.
The amount of the exemption is subject to the
taxpayers filing status and is available to all
taxpayers
The AMT exemption reduces the taxpayers tax
base. like the standard deduction but is phasedout for higher income taxpayers.
The AMT exemption is indexed for inflation and
increases over time.
Taxpayers dont deduct the standard deduction if
they itemize but taxpayers deduct the AMT
exemption amount in any circumstance (unless it
was phased-out).

Alternative Minimum Tax

Exemption phased out 25 cents for each dollar over threshold

7-34

Increased AMT
The AMT exemption amounts and the exemption
phase-out thresholds are indexed for inflation.
Consequently, as taxpayer incomes increase,
more of the income is exposed to the AMT.
Also, individual tax rates have been decreasing
while AMT rates have remained stable.
This increases the likelihood that the TMT
(tentative minimum tax) will exceed the regular
tax liability for an increasing number of
taxpayers.

ALTERNATIVE MINIMUM TAX

AMT is a tax based on an alternative more
inclusive tax base than regular taxable
income.
Meant to ensure that taxpayers are paying some
minimum level of tax.
Pay the AMT only when the tax on the AMT base exceeds
their regular tax liability.
The AMT exemption amounts and the exemption phaseout thresholds are indexed for inflation.
Individual tax rates have been decreasing while AMT rates
have remained stable.
This increases the likelihood that the TMT will exceed the
regular tax liability for an increasing number of taxpayers.

Taxpayers with high state taxes, high real

estate taxes multiple children and high
capital gains ( capital gains increases AMTI)
are more likely to pay AMT.

Tentative Minimum Tax

The tentative minimum tax is the AMT
base multiplied by the AMT rates.
The AMT is the excess of the TMT over
the taxpayers regular tax liability for
the year.
Taxpayers only pay AMT to the extent
their TMT exceeds their regular tax
liability.

TENTATIVE MINIMUM TAX AND

AMT COMPUTATION
Taxpayers compute the tentative minimum tax by
multiplying the AMT base by the applicable AMT
rates. The AMT rate schedule consists of just two
regular brackets as follows:
26 percent on the first $186,300 of AMT base
($93,150 for married taxpayers filing separately).
28 percent on AMT base in excess of $186,300.
($93,150 for married taxpayers filing separately).
For AMT purposes long-term capital gains and
dividends are taxed at the same preferential rate
as they were taxed for regular tax purposes
(generally 0 percent, 15 percent or 20 percent).

ALTERNATIVE MINIMUM TAX

AMT is becoming so prevalent:
Exemption amount and phase-out threshold
not indexed for inflation
Individual tax rates have been decreasing.

AMT rates 26% or 28% vs. individual

ordinary rates 10%, 15%, 25%, 28%, 33%,
35%, 39.6%

FICA Taxes

Employees must pay FICA taxes on their wages.

Tax consists of a Social Security and a Medicare component.
The Social Security tax is intended to provide basic pension
coverage for the retired and disabled.
The Medicare tax helps pay medical costs for qualified individuals.
Employees pay Social Security tax at a rate of 6.2% on the wage
base and
Medicare tax at a rate of 1.45% on their wages up to
$200,000 than 3.8%.
The wage base on which Social Security taxes are paid is limited to
an annually determined amount. (The 2016 limit is $118,500 )
There is no wage base for the Medicare component of the FICA tax.
A taxpayers entire wages will be subject to this portion of the FICA
tax.
Employer pays 6.2% for 2016.
Withholding for Medicare is 2.35% above $200,000/ $250,000 MFJ.
Employers do not pay additional .9% additional Medicare tax.

Self Employed Tax Payers

Self-employed taxpayers must pay FICA tax on their
net earnings from self-employment.
This is 92.35% of their net schedule C income Net of
7.65%.

Same $118,500 limit applies to Social Security portion

The FICA rates for self-employed taxpayers are double

those of employees because self-employed taxpayers
must pay the employees and the employers portions
of the FICA taxes.
The wage base is the same whether the taxpayer is
an employee or is self-employed.
Employees have their FICA tax payments withheld by
their employers while self-employed taxpayers pay
their FICA taxes with their estimated tax payments
and with their tax return.

Employment and SelfEmployment Taxes

Employment FICA Taxes

Employer
Pays normally pays of
employees FICA tax. Employer
pays 6.2%
Withholds FICA tax from
employees pay check
Employee
Must pay FICA taxes on
compensation from employer
Multiple employers during year

Employment and SelfEmployment Taxes

Self-employed taxpayers
Responsible for entire FICA tax

Steps to computing SE tax

Compute net Schedule C income
(generally) and multiply by .9235
This equals net earnings from selfemployment
Determine Social Security tax 12.4%
and Medicare tax 2.9% (2016) + .9%
for Employees over $200,000
$118,500 limit applies to Social
Security portion only.

Employment and SelfEmployment Taxes

If net earnings from self-employment <

$400, no SE tax.
How does $118,500 Social Security
earnings limit apply when have both
wages and SE earnings in the same
year?
Wages use up limit first taxpayer
favorable or unfavorable? Why?

Employment and SelfEmployment Taxes Example

Assume that Courtney received $100,000 of
taxable compensation from EWD in 2016, and she
received $180,000 in self-employment income from
her weekend consulting activities and her husband
received $75,000 from his employer. What amount
of self-employment taxes is Courtney required to
pay on her $180,000 of business income?
Assume that Courtneys employer correctly
withheld $6,200 of Social Security tax, $1,450 of
Medicare tax, and $0 of .9 percent additional
Medicare tax.
7-46

Employment and SelfEmployment Taxes Example

Solution

Employee vs. Independent

Contractor
Determining whether taxpayer is
employee or independent contractor
Primary question: who has control
over how, when, where work is
performed?
Tax differences
Amount of FICA or SE taxes payable
Deductibility of expenses
For AGI
From AGI
One-half of self-employment taxes

The IRS published a list of 20 factors to be considered when making this

determining whether a worker should be classified as an independent
contractor or as an employee. Some of the major factors for making this
determination include the following.
1.If the worker is able to set her own working hours it is more likely that she
will be considered a contractor rather than an employee.
2.If the worker works for more than one firm at a time, she is more likely to be
considered a contractor rather than an employee.
3.If the worker is at risk financially for recognizing a profit or loss, the worker
is more likely to be considered a contractor rather than an employee.
4. If the worker is able to perform work somewhere other than the employers
premises, the worker is more likely to be considered a contractor rather than an
employee.
5.If the worker is able to work without frequent oversight, she is more likely to
be considered a contractor than an employee.
6.If the worker is able to work for more than one firm, the worker is more
likely to be considered a contractor rather than an employee.

Independent Contractors
The primary tax cost for the person classified as an
independent contractor is the payment of FICA taxes.
Contractors are responsible for paying the full FICA tax
burden associated with their income. 12.4% of FICA taxes
until they reach the limit of $118,500. For income above
the limit, contractors pay 2.9% for Medicare
Total of 15.3% in 2016 up to the limit of $118,500.
Contractors are allowed to deduct one half of the self
employment (FICA) taxes they pay. independent
contractors are responsible for paying their own
estimated taxes. The primary tax benefits of being
classified as an independent contractor rather than an
employee center on the deductibility of expenses.
Independent contractors are able to deduct ordinary and
necessary business expenses as for AGI deductions.
This means the contractor may fully deduct the expenses.

Employees
In 2016 Employees are responsible for paying 7.65%
(6.2% + 1.45%) FICA taxes up to the annual limit, after
which they pay 1.45%. The employer pays the other half
of the FICA tax burden. 7.65% (6.2% + 1.45%).

Expenses incurred by employees qualify as

unreimbursed employee business expenses which are
itemized deductions subject to the 2% of AGI floor.
Unless the employee incurs a very large amount of
unreimbursed expenses, the employee will receive no
tax benefit from the deductions.
However, employers generally reimburse employees
for their expenses so none of the cost of these
expenses is deductible as itemized deductions and a
potential tax benefit is not an issue.

Employee vs. Independent

Contractor
Employees

Less control over how, when, and where to perform duties.

Pay 6.2 percent Social Security tax subject to limit.
Pay 1.45 percent Medicare tax.
Independent contractors
More control over how, when, and where to perform duties.
Report income and expenses on Form 1040, Schedule C.
Pay 12.4 percent self-employment (Social Security) tax
subject to limit.
Pay 2.9 percent self-employment (Medicare tax) tax (no
limit).
Self-employment tax base is 92.35 percent of net selfemployment income.
Deduct half of self-employment taxes paid for AGI.
Less costly to hire independent contractor Less
benefits

Tax Credits
Reduce tax liability dollar for dollar
Deductions reduce taxable income
dollar for dollar
Tax Credits consist of three categories
Nonrefundable personal may expire
Refundable personal Business Tax Credits Foreign tax credits
are hybrid and carryover

Tax credits are generally classified

into one of three categories:
1.Nonrefundable personal,
2.Refundable personal, or
3.Business credits depending on the
target for and purpose of the credit.
The type of credit is important because
credits are applied against the gross tax in a
specified order and this determines whether
any excess (unused) credit will be lost
(nonrefundable personal credits), carried over
into another period (business credits), or

Nonrefundable credits can reduce a taxpayers

regular tax liability and AMT liability, but cannot
reduce other taxes (including self-employment
taxes).
When a taxpayers nonrefundable credits exceed
the sum of a taxpayers regular tax liability and
AMT liability, the taxpayer reduces these taxes to
zero but the unused credits expire without
providing any tax benefit unless that unused credit
can be carried to a different tax year.
Refundable credits can reduce a taxpayers regular
tax liability, AMT liability, and other taxes (including
self-employment taxes).
If the amount of a taxpayers refundable credits
exceeds the taxpayers tax liability, the taxpayer
receives a refund of the excess credit.

The proliferation of credits is partly

because credits provide a dollar-for-dollar
reduction in taxes.
Credits do not provide a disproportionate
incentive for taxpayers with the highest
marginal tax rates.
Credits are also extremely flexible in
that they can be used to provide
incentives for transactions which are not
easily addressed by adjustments to the
tax base.
Credits are powerful tools for
accomplishing policy objectives because

Nonrefundable Personal

Child tax credit

$1,000 for each qualifying child under age 17 at end of year
Partially refundable in certain situations
Phase-out amount not percentage - Credit is phased out for married filing
jointly taxpayers with AGI above $110,000 & head of household above
$75,000.
Lose $50 for every $1,000 or portion thereof that AGI exceeds $110,000

Child and Dependent care credit

Dependent under age of 13
a dependent or spouse who is physically or mentally incapable of caring for
herself or himself and who lives in the taxpayers home for more than half
the year.
Percentage of qualifying expenditures
Maximum qualifying expenditures based on AGI: $3,000 one qualifying
person, $6,000 two or more qualifying persons
Percentage depends on AGI (see Exhibit 8-9) - The credit percentage is based
upon the taxpayer's AGI level and begins at 35 percent of qualifying
expenditures for taxpayers with AGI of $15,000 or less. The minimum
dependent care credit is 20 percent of qualifying expenditures for taxpayers
with AGI over $43,000.

Nonrefundable Personal

7-58

Child Credit Phase Out

Exhibit 8-8

Formula for Computing Net Tax

Due

Example
What if:Suppose that Courtney paid a
neighbor $3,200 to care for her 10-year-old
son, Deron, so Courtney could work. Would
Courtney be allowed to claim the child and
dependent care credit for the expenditures
she made for Deron's care?
Answer:Yes. (1) Courtney paid for Deron's
care to allow her to work, and (2) Deron is a
qualifying person for purposes of the credit
because (a) he is Courtney's dependent and
(b) he is under 13 years of age at the end of
the year.

Education Credits
American opportunity credit (AOC) (formerly
Hope scholarship credit) Lifetime Learning
Credit
AOC available for first four years of post-secondary education
For eligible expenses and institutions only
Applied per student
Taxpayer, spouse, taxpayers dependents
Amounts paid by dependents treated as paid by taxpayer
100% of first $2,000 of eligible expenses and 25% of next
$2,000 (maximum credit is $2,500)
Phase-out based on AGI - the credit is phased out pro rata

for taxpayers with AGI between $80,000 and $90,000

($160,000$180,000 for married taxpayers filing jointly).

40% of credit is refundable for 2016.

American Opportunity
Credit Example
Courtney paid $2,000 of tuition and
$300 for books for Ellen to attend the
University of MissouriKansas City
during the summer at the end of her
freshman year. What is the maximum
American opportunity credit (before
phase-out) Courtney may claim for
these expenses?

7-63

American Opportunity
Credit Example Solution
Answer: $2,075.
Because the cost of tuition and books
are eligible expenses, Courtney may
claim a maximum American
opportunity credit before phase-out of
$2,075 [($2,000 100%) + ($2,300 $2,000) 25%].

7-64

American Opportunity
Credit Example Solution
Answer: $2,075.
Because the cost of tuition and books
are eligible expenses, Courtney may
claim a maximum American
opportunity credit before phase-out of
$2,075 [($2,000 100%) + ($2,300 $2,000) 25%].

7-65

American Opportunity
Credit Example
Assuming Courtney qualifies for a
$2,075 American opportunity credit,
she is married filing jointly, and her
AGI is $162,000, what amount of
American opportunity credit would she
be allowed to claim after phase-out?

7-66

American Opportunity
Credit Example Solution

7-67

Lifetime learning credit Non

Refundable
Eligible expenses (tuition & fees & not
books) for post-secondary education
Includes professional or graduate school
Includes continuing education

Applied per taxpayer

MFJ return is limited to one taxpayer

20% of up to $10,000 of eligible expenses $2,000

Phase-out based on AGI for 2015 - phased
out pro rata for taxpayers with AGI between
$55,000 and $65,000 ($110,000 $130,000
for married taxpayers filing jointly).

Education Credits
Continued
If deduct for AGI educational expenses for
someone, no education credit allowed for that
person (assuming for AGI deduction applies in
2016)
Could take American opportunity credit for one
dependent and for AGI deduction for another
taxpayers may choose which credit to use: Either
(1) deduct qualifying education expenses of an
individual as a for AGI deduction or claim an
education credit for the individual's expenses.
If a taxpayer claims any educational credit for an
individual's educational expenditures, the taxpayer
may not claim any for AGI deduction for that
individual's qualifying expenditures (and vice versa

Education Credits - Summary

The lifetime learning credit and the American
opportunity (AOC) credit are similar in the
sense that they are credits for postsecondary
education.
A taxpayer may claim either credit for
qualifying expenditures they make on behalf
of the taxpayer spouse, or dependent of the
taxpayer.
Could take American opportunity credit for
one dependent and for AGI deduction for
another.
Both credits are phased-out based on AGI
and both credits are at least partially
nonrefundable credits.

The credits are different in the sense that qualifying

expenditures for AOC include tuition, fees, and required
course materials (including book) while qualifying
expenditures for the lifetime learning credit includes
tuition and fees but not required course materials.
Further, the AOC applies only to the first four years of
postsecondary education while the lifetime learning
credit has no such restriction.
The AOC carries a per student limit (a taxpayer may
claim more than one credit in a year if the taxpayer pays
the education costs of more than one student).
The lifetime learning credit limit is a per taxpayer credit
(the taxpayer may claim only one credit per year).
The maximum AOC (per student) for a year is $2,500
while the maximum lifetime learning credit for a
taxpayer is $2,000. Finally, the AOC phases out at
higher levels of AGI than the lifetime learning credit and
40% of the otherwise allowable AOC is refundable

Earned income credit

Designed to help offset the effect of employment
taxes on compensation paid to low-income
taxpayers and to encourage lower-income
taxpayers to seek employment.
Taxpayers with investment income such as
interest, dividends, and capital gains in excess of
$3,200 are ineligible for the credit
Negative income tax - if the credit exceeds the
tax after considering nonrefundable credits the
taxpayer receives a refund for the excess
Must have earned income
Must have at least one qualifying child or must be
at least 25 years old and less than 65 and not a
dependent of another
See Exhibit 8-10

Refundable Personal

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Earned Income Credit

The earned income credit is a refundable
credit that is designed to help offset the
effect of employment taxes on
compensation paid to low- income
taxpayers
Earned income credit encourages lowerincome taxpayers to seek employment.
Because it is refundable, it is sometimes
referred to as a negative income tax.
Where the credit exceeds the tax after
considering other nonrefundable credits the
taxpayer receives a refund for the excess.

Earned Income Credit College

Student
A college student may qualify for the
earned income credit if she has earned
income during the taxable year and
(1) has at least one qualifying child who
lives
in her home for more than half of the
year or
(2) does not have a qualifying child for the
taxable year but she lives in the United States
for more than half the year, is at least 25
years old but younger than 65 years old at
the end of the year, and is not a dependent of
another taxpayer

Other Refundable
Personal Credits
Portion of the child tax credit
Excess FICA withholdings
Taxes withheld on wages and
estimated tax payments

Business Tax Credits

Nonrefundable
Promote certain behaviors
If credit exceeds tax, carry back one year and
carry forward 20 years
Foreign tax credit
Hybrid business and personal nonrefundable;
carry back one year and carry forward 10 years
individuals may be allocated business credits from
flow-through entities (partnerships, LLCs, and S
corporations).
Individuals working as employees overseas or
receiving dividends from investments in foreign
securities may qualify for the foreign tax credit.

Foreign Tax Credit

(1) Taxpayers may exclude the foreign earned income from
U.S. taxation (in which case they would not deduct or
receive a credit for any foreign taxes paid); (2) taxpayers
may include the foreign income in their gross income and
deduct the foreign taxes paid as itemized deductions; or (3)
taxpayers may include foreign income in gross income and
claim a foreign tax credit for the foreign taxes paid.
The foreign tax credit helps reduce the double tax
taxpayers may pay when they pay income taxes on foreign
earned income to the United States and to foreign
countries. Taxpayers are allowed to claim a foreign tax
credit, against their U.S. tax liability, for the income taxes
they pay to foreign countries.
Restrictions on taking the tax credit may apply when the
taxpayer's effective foreign tax rate is higher than the
effective U.S. tax rate on the foreign earnings.
Taxpayers generally benefit from claiming credits rather
than deductions for foreign taxes paid because credits
reduce their liabilities dollar for dollar.
When the foreign tax credit is restricted, taxpayers may
benefit by claiming deductions for the taxes paid instead of
credits.

Credit Application Sequence

Credits are applied against a taxpayer's gross tax.
Nonrefundable personal credits and business credits may be used
to reduce a taxpayer's gross tax to zero, but not below zero.
A refundable credit may reduce a taxpayer's gross tax below zero.
This excess refundable credit generates a tax refund for the
taxpayer.
When a nonrefundable personal credit exceeds the taxpayer's
gross tax, it reduces the gross tax to zero, but the excess credit
disappears.
Taxpayer may not carry over any excess nonrefundable personal
credits to use in other years.
However, when a business credit or foreign tax credit exceeds the
gross tax, it reduces the taxpayer's gross tax to zero, but the
excess credit may be carried forward or back to be used in other
years when the taxpayer has sufficient gross tax to use the credit.
When taxpayers have multiple credit types in the same year,
credits are applied against their gross tax in the following order:
(1) nonrefundable personal credits, (2) business credits, and (3)
refundable credits

EXHIBIT 8-12 Credit Application

Order in which the credits are applied
against gross tax and the tax
treatment of any excess credits.
Credit Application

Prepayments and Filing

Requirements
Taxes must be paid-as-you-go
Withholdings From Salary
Treated as made equally throughout the year

Estimated tax payments Self Employed

Due on April 15th,, June 15th, September 15th, and
January 15th of the following year

Safe-harbor requirements No penalties

(1) 90% of current tax liability or
(2) 100% of previous years tax liability (110%
with higher AGI > $150,000) 25% at each
estimated filing deadline

Prepayments and Filing

Requirements

The income tax must be prepaid via withholding from

salary or through periodic estimated tax payments
during the tax year.
Employers are required to withhold taxes from an
employees wages based upon the employees marital
status, exemptions, and estimated annual pay.
Wages include both cash and noncash remuneration
for services, and employers remit withholdings to the
government on behalf of the employee.
At the end of the year employers report the amounts
withheld to each employee via form W-2.

Estimated tax payments are required only if

withholdings are insufficient to meet the taxpayers
tax liability.
For calendar year taxpayers, estimated tax payments
are due on April 15th, June 15th, and September 15th
of the current year and January 15th of the following
year.

Underpayment penalties
Applied on quarterly basis

90%/4 = 22.5% of current year liability must

be paid in by deadline or
100%/4 = 25% of previous years liability
must be paid in by deadline

Penalty based on amount of

underpayment at each quarter x federal
short term rate + 3%

Filing Requirements
Generally, must file if gross income >
standard deduction + personal exemption
amounts
If married filing separately must file if gross
income > personal exemption amount
Lower thresholds for those claimed as
dependent on anothers tax return
Due dates
April 15th
Extend filing up to six months
May not extend due date for paying taxes

Filing requirements
Individual taxpayers are required to file a tax return
if their gross income exceeds certain thresholds,
which vary based on the taxpayers filing status
(e.g., single, married filing jointly, etc.), age, and
gross income (i.e., income before deductions).
The gross income thresholds are indexed for
inflation and thus change annually.
A taxpayer may prefer to file a tax return even
when a return is not required.
A taxpayer with gross income less than the
threshold may want to file a tax return to receive a
refund of income tax withheld.
A taxpayer should file a tax return even if it is not
required to get a refund.

Late Filing and Payment

Penalties

Late filing penalty

5% of tax owed per month up to 25% if not fraudulent;
15% of tax owed per month up to 75% if fraudulent
No penalty if no tax is due
Late payment penalty
If dont pay entire tax owed by due date of return
.5% of amount due up to 25% maximum if not
fraudulent
15% of amount due per month up to 75% if
fraudulent

Combined late filing and late payment

penalties may not exceed maximum amounts for
either one

Penalties for Failure to File

The tax law imposes penalties on taxpayers that do not file
a tax return (by the original due date plus extension) or pay
the tax owed (by the original due date).
The failure to file penalty equals 5 percent of the amount
of tax owed for each month (or fraction thereof) that the tax
return is late with a maximum penalty of 25 percent.
The late payment penalty equals .5 percent of the amount
of tax owed for each month (or fraction thereof) that the tax
is not paid.
The combined maximum penalty that may be imposed for
late filing and late payment is 5 percent per month
(25 percent in total).
The late filing and late payment penalties are higher if
fraud is involved.

Late Filing and Late Payment Penalty

Example
Assume Courtney filed her tax return on
April 10 and included a check with the
return for $2,860 made payable to the
United States Treasury. The $2,860
consisted of her underpaid tax liability of
$2,830 and her $30 underpayment penalty.
If Courtney had waited until May 1 to file
her return and pay her taxes, what late
filing and late payment penalties would
she owe?
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Late Filing and Late Payment Penalty

Example Solution
Answer: Her combined late filing
penalty and late payment penalty
would be $142 ($2,830 late payment
5 percent 1 month or portion
thereof). Note that the combined late
filing and late payment penalty is
limited to 5 percent per month.

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