ch14

Copyright © 2015 Pearson Education, Inc. I:14-1

Chapter I:14

Special Tax Computation Methods, Tax Credits, and Payment of Tax

Discussion Questions I:14-1 Most taxpayers are not subject to the alternative minimum tax (AMT) because they do not have substantial tax preferences and AMT adjustments and because there is a liberal exemption amount to reduce the tax base on which the AMT is calculated. However, more and more taxpayers in recent years are being subjected to the AMT. p. I:14-2. I:14-2 No, the alternative minimum tax does not apply if an individual's tentative minimum tax is less than his regular tax liability. It applies only if the tentative minimum tax exceeds the regular tax liability. p. I:14-3. I:14-3 b. only. Only excess depreciation for real property placed in service before 1987 is a tax preference item. For tax years prior to 1987, net long-term capital gains were a tax preference item (i.e., the 60% long-term capital gain deduction) and for taxable years prior to 1993 the appreciated portion of the fair market value of capital gain real property contributed to charity was a tax preference item. p. I:14-4. I:14-4 a, b, c only. Itemized deductions that are not allowed in computing AMTI, excess depreciation on real property placed in service after 1986, and excess MACRS depreciation for personal property placed in service between 1987 and 1998, are all AMT adjustments. Tax-exempt interest is not an AMT adjustment but may be a tax preference item if the bonds are private activity bonds. pp. I:14-4 through I:14-6. I:14-5 a and b only. Charitable contributions and mortgage interest related to the purchase of a personal residence are deductible when computing AMT. Investment interest is deductible up to the amount of qualified net investment income. Because the individual has no investment income, the investment interest expense is not deductible. Medical expenses are deductible only for amounts in excess of 10% of AGI and state and local taxes are not deductible for AMT purposes. pp. I:14-4 and I:14-5. I:14-6 Most people are not subject to the self-employment tax because they are classified as employees for tax purposes. Employees pay employment taxes through withholding and in amounts which must be matched by their employers. p. I:14-8. I:14-7 Tony will have to make Social Security tax payments in the form of self-employment taxes if he continues to operate his consulting business as a sole proprietor. If Tony continues to be employed, he will not be subject to the Social Security portion of the self-employment tax on the first $117,000 (2014) of total earnings. However, all earning are subject to the Medicare portion of the FICA tax (1.45% for employment related income and 2.9% for his


self-employment earnings). If he retires from his salaried job, Tony's consulting income will all be subject to the 15.3% self-employment rate on the first $117,000 and 2.9% on income in excess of $117,000. Tony will then receive a for AGI deduction for 50% of Social Security and Medicare taxes paid. pp. I:14-8 and I:14-9. I:14-8 If the engagement is set up as a consulting arrangement rather than an employment contract, then the consulting firm will be able to avoid making matching FICA contributions for Theresa’s earnings and not be required to withhold the employee's share of FICA tax. Thus, if the compensation paid to Theresa would be the same whether she was an employee or independent consultant, the cost of Theresa’s services would be less if she were a consultant rather than an employee. Theresa, however, will be subject to the self-employment tax. If her income as an employee (e.g., college professor) is in excess of the ceiling amount of $117,000 (2014) for the Social Security portion of self-employment income, she will not be subject to the 12.4% Social Security portion of the tax. She will however, be subject to the 2.9% Medicare portion on her self-employment income. Thus, receiving compensation as a consultant is more expensive to Theresa. p. I:14-8. I:14-9 a. The couple’s AMT exemption equals $81,225.

$82,100 – [25% X ($160,000 - $156,500)] = $81,225 b. If the couple’s AMTI increases by $200,000, their AMT exemption will be $31,225.

$82,100 – [25% X ($360,000 - $156,500)] = $31,225 pp. I:14-3 to I:14-4. I:14-10 a. Foreign tax credits are provided to mitigate the effect of double taxation on foreign source income. b. The research credit is given to encourage (reduce the after tax cost of) research and development activities. c. Business energy credits are incentives to encourage energy conservation measures and the use of fuel other than petroleum. d. The premium tax credit is designed to make the cost of health insurance more affordable for taxpayers with relatively low household incomes. e. The child and dependent care credit was enacted to reduce the cost of quality child care for parents and other individuals who are employed and who must incur expenses for household and dependent care services. f. The earned income credit is designed to encourage low-income individuals to become gainfully employed or to continue to work despite low earnings. g. The purpose of the American Opportunity tax credit is to reduce the cost of postsecondary education for low and middle income taxpayers. h. The disabled access credit is designed to reduce the cost of adding disabled access to existing business facilities. i. The adoption credit is designed to reduce the financial burdens associated with adopting children. Topic Review I:14-2 and page I:14-26. I:14-11 To a taxpayer in the 15% marginal tax bracket, a $200 deduction is worth $30 in tax savings and is therefore worth less than a $40 credit. To a taxpayer in the 25% marginal tax


bracket, the deduction is worth $50 in tax savings, more than a $40 credit. Thus, for all taxpayers with a marginal tax rate of 25% or more, the deduction is more advantageous than the credit. p. I:14-10. I:14-12 The general business credit includes the rehabilitation expenditures credit, research credit, business energy credits, and the disabled access credit. pp. I:14-19 through I:14-25. I:14-13 a. The general business credit may not exceed the "net income tax" minus the greater of (1) the tentative minimum tax or (2) 25% of the "net regular tax liability" in excess of $25,000. b. The general business credit is a nonrefundable credit and has a lower priority than personal tax credits. An individual must use personal tax credits as well as the foreign tax credit to offset tax liability before the general business credit is used. Since the credit is nonrefundable, if the tax liability has already been eliminated by credits with a higher priority than the general business credit, the taxpayer will only be able to carryback or carryforward the unused general business credit. c. For tax years beginning after December 31, 1997, the general business tax credit may be carried back 1 year and any remaining credit may be carried forward 20 years. Credits arising from prior years (commencing with the earliest carryover years) are first carried back or forward before credits arising from the current year may be used. p. I:14-23. I:14-14 a. The foreign tax credit is equal to the income tax paid or accrued to a foreign country, but limited to the taxpayer's U.S. tax liability multiplied by the ratio of foreign source taxable income to worldwide taxable income. This limitation restricts the use of foreign tax credits when the effective foreign tax rate exceeds the effective U.S. tax rate. In this case, the effective foreign tax rate is lower than the effective U.S. tax rate, and the foreign tax credit would be $24,000 ($120,000 x 0.20), the foreign tax paid. b. In this case Sarah would be better off choosing the earned income exclusion because $99,200 (2014) of her income could be excluded from U.S. taxation.

1. If Sarah elects the foreign-earned income exclusion,

U.S. taxable income after exclusion ($120,000 − 99,200)

$20,800

U.S. tax rate U.S. tax

x 0.30 $ 6,240

Foreign tax credit ($20,800 x 0.20) Net U.S. tax liability

( 4,160) $ 2,080

Plus: Foreign tax paid Total taxes paid $ 26,080

24,000

Sarah is eligible for a foreign tax credit on the $20,800 of foreign earned income subject to U.S. tax.


2. If Sarah elects the foreign tax credit, U.S. tax on worldwide taxable income ($120,000 x 0.30)

$36,000

Foreign tax credit ($120,000 x 0.20) ( 24,000Net U.S. tax liability

) $ 12,000

Plus: Foreign tax paid Total taxes paid

24,000 $ 36,000

Ultimately, Sarah pays the higher tax rate (30%) on the $120,000 income: 20% to the foreign country and 10% (after FTC) to the U.S.

pp. I:14-18 and I:14-19. I:14-15 The penalty tax associated with failing to obtain minimum essential health insurance coverage is set at the greater

of 1) $95 or 2) 1% of household income for 2014. For the taxpayer described in the problem, the penalty will equal $550, the greater of 1) $95 or 2) $550 (1%*$55,000). pp. I:14-24 to I:14-26.

I:14-16 The credit is $5,000 (0.50 x $10,000). Only $10,000 of the $15,000 expenditure qualifies for the credit (expenditures over $250 but not exceeding $10,250, or $10,000 maximum). The depreciable basis of the property is reduced by the $5,000 allowable credit. Queen Corporation is eligible for the disabled access credit as an eligible small business. Though the company had $1 million or more of gross receipts in the preceding year, it meets the alternate test because it had fewer than 30 employees (24). pp. I:14-22 and I:14-23. I:14-17 a. The credit applies to expenditures for the rehabilitation of older industrial and commercial buildings and certified historic structures. Expenditures may not be for residential real estate unless the structure is a certified historic structure. b. A rate of 10% applies to expenditures on structures placed in service before 1936 and a rate of 20% to expenditures on certified historic structures. c. Depreciation of qualifying expenditures must be computed using the straight-line depreciation method. d. For the purpose of depreciation, the basis of the property must be reduced by the full amount of the credit taken. e. The rehabilitation credit must be recaptured at a rate of 20% per year in the event of an early disposition of the property (within 5 years). pp. I:14-19 to I:14-20. I:14-18 Solar energy property and geothermal energy property qualify for the business energy credit. Solar energy property is eligible for an increased credit of 30% of basis for years 2006-2016. p. I:14-20. I:14-19 Many personal tax credits are motivated by both economic and social policy objectives. For example, the dependent care credit makes it profitable for more parents to work and provide adequate child care. p. I:14-10.


I:14-20 A refundable tax credit resembles a direct subsidy. It is a type of negative income tax. If the credit exceeds the tax liability, the government pays the taxpayer the excess credit. A nonrefundable tax credit may only be used to offset the taxpayer’s tax liability. Therefore, if the credit exceeds the tax liability, the taxpayer receives no payment and, at best, can only carryback or carryforward the excess credit. The earned income credit is a refundable tax credit. Child and dependent care credits and tax credits for the elderly are examples of nonrefundable credits. p. I:14-23. I:14-21 If an individual is unemployed and has no earned income, it is generally not possible to receive a child and dependent care credit because eligible expenses are limited to earned income. One exception to this rule is a spouse who is either a full-time student or incapacitated. Such individuals are deemed to have earned income of $250 per month (one qualifying dependent) or $500 per month (two or more qualifying dependents). pp. I:14-11 and I:14-12. I:14-22 There are several significant differences between the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit (LLC). First, the AOTC only applies during a student’s first four years of post-secondary education, whereas the LLC applies to undergraduate, graduate, and professional education. Second, the AOTC applies per student (maximum $2,500 per student) whereas the LLC applies per taxpayer, based on the dollars spent on qualified tuition and related expenses by the taxpayer. Finally, the AOTC and LLC have different phaseout rules. Low- and middle- income taxpayers most likely qualify for both credits. However, the LLC phase-out occurs at lower income levels. Because the LLC phaseout ranges are adjusted annually for inflation (and AOTC ranges are fixed), over time, this may decrease in importance as a disadvantage. pp. I:14-14 to I:14-16. I:14-23 The maximum amount of child and dependent care expenses that qualify for the credit for a taxpayer with two or more qualifying individuals is $6,000. A taxpayer who has $8,000 of eligible expenses may claim a maximum credit of $2,100 ($6,000 x 0.35). The credit rate decreases to a minimum of 20% as the taxpayer’s AGI increases from $15,000 to $43,000. If the taxpayer’s AGI exceeds $43,000, the maximum credit is $1,200 ($6,000 x 0.20). pp. I:14-11 and I:14-12. I:14-24 The allowable credit equals $600 (30% credit rate x $2,000 allowed expenses). Vivian's child and dependent care expenses are limited first by the $6,000 ceiling amount, and second, the $6,000 is reduced to $2,000 by the $4,000 employer reimbursement. Her credit rate is 30% because her AGI of $24,500 exceeds the base AGI of $15,000 by $9,500. Thus, the basic 35% credit is reduced by 5% to 30% ($9,500/$2,000 = 4.75, rounded to 5%). pp. I:14-11 and I:14-12. I:14-25 a. The adoption credit allowed is the amount of qualified adoption expenses incurred up to a maximum of $13,190 (2014). The credit must be used in the year adoption is finalized for qualified expenses paid both in the finalized year and in prior years. The credit must be used in the year qualified expenses are paid if paid in years after the finalized year. This rule is intended to prevent taking a credit for adoption expenses where the adoption is not finalized. Finally, there is a phase-out of the credit based on the taxpayer's AGI. For taxpayers with AGI above $197,880 (2014), the credit is ratably phased-out and is fully phased-out when AGI reaches $237,880.


b. As with other phase-outs in the tax law, Congress did not intend this credit for higher-income taxpayers. Whether adoption is affordable may not influence adoption decisions for high income households. pp. I:14-13 and I:14-14. I:14-26 The credit allowed equals $4,666 ($5,460 - $794). Alice is eligible for the earned income credit (EIC) since she has qualifying children and has earned income which does not exceed the phase-out limitation amounts. Her initial credit amount for 2014 is $5,460 (40% of the lesser of $18,000 earned income or $13,650). The phase-out amount is $794 (.2106 × ($21,600 -$17,830)). The provision allowing for advance payment of EIC expired after 2010. pp. I:14-23 to I:14-24. I:14-27 Most elderly people are unable to qualify for the credit because they receive Social Security benefits which exceed the ceiling limitation, or they have AGI in excess of the limitation, or both. p. I:14-13. I:14-28 Penalties are imposed if an employer fails to withhold federal payroll tax and income tax and pay them to the IRS. Corporate officers, directors, and other officials may be held personally liable for payment of the tax. p. I:14-25. I:14-29 a. Given the budget constraints of lower and middle income households, Congress wanted to enact this credit to further encourage saving for retirement. Further, Congress acknowledged that the United States has a low savings rate, especially among lower and middle income households. b. The credit is computed by multiplying qualifying contributions (maximum $2,000 per taxpayer per year) by an applicable percentage between 50% and 10%, depending on the taxpayer’s adjusted gross income and filing status. Therefore, the maximum annual credit equals $1,000 ($2,000 x 0.50). p. I:14-17. I:14-30 a. The two components of the credit for employer-provided childcare are (1) qualified childcare expenses (expenses paid to acquire, construct, rehabilitate, expand, and operate a qualified childcare facility), and (2) qualified child care resource and referral expenditures (expenses paid to provide child care resource and referral services for employees). b. The credit equals 25% of qualified childcare expenses plus 10% of qualified childcare resources and referral expenditures. The total credit for an employer is limited to $150,000 for any given tax year. Finally, if an employer ceases its childcare operations within the first three years, 100% of the credit is recaptured. pp. I:14-20 to I:14-21. I:14-31 The research credit is allowed for increasing research expenditures. The credit is 20% of the excess of qualified research expenses for the taxable year over an established base amount. The objective of increasing research activity is met by the incremental nature of the credit. An exception exists. The simplified approach to calculating the research credit allows a credit of 6% of qualified research expenses if the taxpayer had no such expenses in the 3 prior years. pp. I:14-23 and I:14-24.


I:14-32 a. Yes, a person may claim fewer allowances than allowed. b. An individual might claim fewer allowances to increase the amount of tax withheld, if she anticipates that taxes will be owed at the end of the year and she does not wish to make quarterly estimated tax payments. This situation occurs for taxpayers earning wages andc. Virginia can claim more than five withholding allowances in a tax year if she has larger than average deductible expenses (for example, mortgage interest expenses on a new house that are substantially larger than the average for a family of Virginia’s income amount).

nonwage income.

p. I:14-28. I:14-33 a. Mario should file exempt status on a Form W-4 to avoid having amounts withheld. b. Mario would receive a smaller paycheck each period due to withholding. Since he owes no taxes, he would be entitled to a refund of all withholding amounts. In effect, Mario would be loaning the government the withholding amount interest-free. p. I:14-28. I:14-34 Backup withholding was implemented to prevent abusive noncompliance with tax provisions (e.g., where the taxpayer fails to provide the payor with his tax identification number, or fails to report this type of income on his return). Backup withholding provides for withholding of taxes at 28% from pension income, interest, dividends, and royalties under certain circumstances. p. I:14-28. I:14-35 a. Vincent is not required to make tax payments for 2014 to avoid the underpayment penalty since he had more withheld in 2014 ($9,000) than 100% of his previous year tax liability ($8,000), and his previous year AGI was less than $150,000. b. No. Since Vincent has withholding for 2014 of $9,000, which exceeds 100% of his 2013 tax liability, he will not be subject to an underpayment penalty. c. Because his 2013 AGI was more than $150,000, to avoid the underpayment penalty for tax year 2014, Vincent’s estimated tax payments must total at least $8,800 (110% x $8,000). His 2014 withheld federal income tax of $9,000 is greater than the minimum, so no penalty is imposed. pp. I:14-29 to I:14-30.

I:14-36 To avoid the estimated tax underpayment penalty, the taxpayer should make certain that his combined estimated payments and withholdings equal to the required percentage of the preceding year’s tax liability. A taxpayer must pay in 100% of the preceding year’s tax liability if his AGI was $150,000 or less in the previous year. If the taxpayer’s previous year AGI exceeded $150,000, to avoid the penalty, for the current year, the taxpayer would need to pay 110% of his previous year tax liability. p. I:14-31. I:14-37 It is preferable to have an underpayment of the tax liability because the IRS does not pay interest on overpayments if it refunds the overpayment within 45 days from the later of the due date of the return or its filing date. Overpaying is similar to making an interest free loan to the IRS. p. I:14-32. I:14-38 Many people overpay their taxes in the form of additional withholding to be sure that they will not have to pay a lump-sum tax payment at the filing date (using the withholding system as a "forced savings" program). As mentioned previously, the disadvantage with this forced savings is that no interest is earned on such savings. p. I:14-32.


Issue Identification Questions I:14-39 The primary issue is the impact of paying self-employment taxes directly versus continuing to pay FICA taxes via withholding from his employment income. In addition, Daryl should consider the effect of the change on his marginal tax rate and the tax treatment of his pension benefits. He should also consider the loss of tax-free employee fringe benefits, such as employer contributions to accident and health insurance, and the need to acquire essential health insurance to avoid the tax penalty imposed on taxpayers who fail to obtain health insurance coverage. pp. I:14-29 and I:14-30. I:14-40 Given a $30,000 taxable income increase, the primary issue is whether Jennifer should make quarterly estimated tax payments to avoid an underpayment penalty. She needs to consider whether she can avoid the underpayment penalty by meeting one of the exceptions. A secondary issue is the tax treatment accorded the property settlement and the tax basis of the securities. While the securities are not subject to income taxation pursuant to the divorce, they do have a carryover basis. If the basis is low, Jennifer may recognize a sizeable gain if she sells the securities. Again, estimated taxes must be paid on such a gain to avoid underpayment penalties. p. I:14-29. I:14-41 Option A: In 2014, declining coverage will cost Dale the penalty tax, equal to the greater of 1) $95 or 2) $650 (1% of household income (1% * 65,000)). The “net of health insurance related costs” compensation will equal $64,350 ($65,000 - $650). Option B: In 2014, accepting and paying for 1/3 of the cost of health insurance will cost Dale $1,200 (12 months * $100 per month). The “net of health insurance related costs” compensation will equal $63,800 ($65,000 – employee payments $1,200). However, Dale will have a nontaxable benefit to add to his compensation: the employer’s payment of $2,400 (12 months * $200 per month) is a tax-free fringe benefit. The overall “net of health-insurance related costs” compensation should be increased to $66,200 [($65,000 + 2,400 fringe benefit) - $1,200 employee payments)]. Present evidence to support the value of health insurance coverage (at least $3,600). If Dale continues to resist the idea, notify him that his costs will increase under the penalty tax in 2015 and 2016 as follows. 2015 penalty tax: greater of $395 or 1% of household income ($650) 2016 penalty tax: greater of $695 or 1% of household income ($650). After 2016, the $695 flat amount will continue to increase because it is indexed to inflation. pp. I:14-24 to I:14-26.


Problems I:14-42 a. Taxable income $ 70,000

Plus: Tax preference items 20,000 Plus: AMT Adjustments

Personal and dependency exemptions ($3,950 x 2) 7,900 Adjustment related to itemized deductions

AMTI $112,900 15,000

Minus: Exemption (no phaseout) ( 82,100) Alternative minimum tax base $ 30,800 Tentative minimum tax ($30,800 x 0.26) $ 8,008

Minus: Regular tax ( 9,593) Alternative minimum tax $ 0

b. Taxable income $ 70,000

Plus: Tax preference items 20,000 Plus: AMT Adjustments

Personal and dependency exemptions ($3,950 x 1) 3,950 Adjustment related to itemized deductions 15,000

AMTI $108,950 Minus: Exemption (no phaseout) (52,800)

Alternative minimum tax base $ 56,150 Tentative minimum tax ($56,150 x 0.26) $ 14,599 Minus: Regular tax ( 13,356) Alternative minimum tax $ 1,243

pp. I:14-2 through I:14-7. I:14-43 Regular taxable income $160,000

AMT preferences 10,000 AMT adjustments Adjustments related to itemized deductions 30,000 Personal exemption 3,950 AMTI $203,950 Minus: Exemption ($52,800 - 0.25($203,950 - $117,300)) ( 31,138) AMT tax base $172,812 Tentative minimum tax ($172,812 x 0.26) $ 44,931 Minus: Regular tax ( 37,976) Alternative minimum tax $ 6,955

pp. I:14-3 and I:14-4.


I:14-44 a. Harry and Mary’s regular tax and AMT are computed as follows:

Regular Tax: Salary $100,000 Interest and dividends 8,000 AGI $108,000 Standard deduction $12,400 Personal exemptions (14 x $3,950) 55,300 (67,700) Taxable income

Regular income tax Child tax credit ($1,000 x 6) Net regular tax (refundable portion of

child tax credit)

$ 40,300 $ 5,138 (6,000) $ (862)

Alternative Minimum Tax: Taxable income (above) $ 40,300 Plus: AMT Adjustments Personal exemptions Standard deduction

55,300 12,400

AMTI $108,000 Minus exemption (no phaseout) (82,100) AMT base $ 25,900 Pre-credit tentative minimum tax

Child tax credit ($25,900 x 0.26) $ 6,734 (6,000)

Tentative minimum tax $ 734 Net regular tax ( -0-) Alternative minimum tax $ 734

b. The imposition of AMT on Harry and Mary likely is not what Congress intended when the AMT was enacted. pp. I:14-3 through I:14-7.

I:14-45 a.

Medical expenses [($2,500 ($10,000 - $7,500) for regular tax - $2,500 ($10,000 - $7,500) for AMT)] $ 0

Real estate taxes 8,000 State income taxes 5,000 Total adjustments related to itemized deductions $13,000


b. Taxable income $48,000 Plus: Tax preferences 20,000 Plus/Minus: AMT Adjustments Personal Exemption 3,950 Related to itemized deductions 13,000 AMTI $84,950 Minus: Exemption (no phaseout) ( 52,800) Alternative minimum tax base $32,150 Tentative minimum tax ($32,150 x 0.26) $ 8,359 Minus: Regular tax liability ( 7,856) Alternative minimum tax $ 503

pp. I:14-3 through I:14-7. I:14-46 a. SE tax = Social security tax + Medicare tax = $8,016 + $1,875 = $9,891 Social security tax = 12.4% x lesser of 1) or 2) below = 12.4% x 64,645 = $8,016 1) $64,645 net SE income [$70,000 * .9235] or 2) $72,000 Social Security base ceiling reduced by wages [$117,000 - $45,000] Medicare tax = 2.9% x net SE income = 2.9% x $64,645 = $1,875 Deduction for SE tax = 50% x $9,891 = $4,946 b. SE tax = Social security tax + Medicare tax = $0 + $1,875 = $1,875 Social security tax = 12.4% x lesser of 1) or 2) below = 12.4% x $0 = $0 1) $64,645 net SE income [$70,000 * .9235] or 2) $0 Social Security base ceiling reduced by wages [$117,000 - $120,000] Medicare tax = 2.9% x net SE income = 2.9% x $64,645 = $1,875 Deduction for SE tax = 50% x $1,875 = $938 pp. I:14-8 to I:14-10. I:14-47 Arnie: A partner’s income from a partnership is considered self-employment income. Arnie’s self-employment tax is computed as follows:

Net SE income: ($75,000 x 0.9235) = $69,263 Social Security tax: $69,263 x 0.124 $ 8,589 Medicare tax $69,263 x 0.029 2,009 Total SE tax $10,598

Note: Though Arnie and Angela are married, their self-employment taxes are computed separately. Angela’s earnings as an employee are not considered in evaluating Arnie’s SE income relative to the Social Security ceiling.


Angela is not self-employed and is therefore, not subject to the SE tax. She pays the employee share of FICA (Social Security and Medicare) via wage withholding. pp. I:14-8 and I:14-9. I:14-48 a. Director Fees $ 11,000 Consulting loss (6,000) Gross SE income $ 5,000

× .9235 Net SE income $ 4,618 Social Security tax: $4,618 x 0.124 = 573 Medicare tax: 4,618 x 0.029 = 134 SE tax $707 Taxpayers may deduct losses from self-employment activities against self-employment income. Anita incurred a $6,000 loss from her consulting practice, and this amount offset her $11,000 of director’s fees. b. SE tax = Social Security tax + Medicare tax = $0 + $134 = $134 Anita will not pay Social Security tax because her salary is greater than the maximum OASDI amount of $117,000. The Medicare portion of her SE tax equals $134 ($4,618 x 0.029). pp. I:14-8 and I:14-9. I:14-49 a. Allowable personal tax credits total $3,200 ($2,000 + $1,200). b. Total business tax credits are $1,500 ($900 + $600).

The allowable amount of the business tax credit is $800 ($4,000 tax - $3,200 of personal tax credits). c. Unused business tax credits of $700 ($1,500 - $800) may be carried back one year and carried forward 20 years. pp. I:14-10 through I:14-24. I:14-50 a. The credit equals $1,200 ($6,000 x 0.20). The limitation on qualifying expenses is $6,000 (2 qualifying dependents × $3,000 each). Since AGI is greater than $43,000, the credit rate is 20%. b. The credit is still $1,200.

Payments to relatives are qualified payments as long as the relative is not a dependent or child (under age 19) of the taxpayer. c. The credit is $580 [(0.29 x ($3,000 - $1,000)].

Qualifying expenses are limited to $3,000 for the one child under age 13. The $1,000 excluded from Bruce's gross income under Sec. 129 must reduce qualified expenses. AGI exceeds $15,000 by $12,000, so the credit rate is 29%. d. The credit is $800 (0.20 x $4,000).

Qualifying expenses are limited to $4,000. (The lower earned income of Candice). The credit rate is 20% because AGI exceeds $43,000.


e. The credit is $1,000 ($5,000 x 20%). The amount of qualifying expenses is generally limited to the earned income of the lesser earning

spouse. Ben has no earned income during the year, but because he is a full-time student, with two qualifying children, he is treated as earning $500 per month, or $5,000 (10 months x $500). The credit rate is 20% because AGI exceeds $43,000. pp. I:14-11 and I:14-12. I:14-51 a. Valerie and Brad's qualified adoption expenses include: 2013 2014 Total

Agency fees $ 5,000 $ 4,000 Travel expenses 1,500 400 Publications 300 0 Legal fees 1,000 0 Court costs 0 1,500 TOTAL $ 7,800 $ 5,900 $13,700

The publications qualify if they are directly related to, and have the principal purpose of the legal adoption of an eligible child. [Sec. 23(d)]. The kennel fees for the dog and the cost of nursery furniture are not qualified expenses. The qualified adoption expenses paid in 2013 are not eligible for the credit until the year the adoption is finalized, 2014. So, no credit is allowable in 2013. b. The maximum credit is $13,190, which may be taken in 2014, the year the adoption is final. They incurred $13,700 of qualified expenses, but the credit amount is limited to $13,190. c. The credit would still equal $13,190. $13,190 is the maximum even for a child with special needs. The law also provides that an adoption credit of $13,190 is allowed for a child with special needs regardless of how much the taxpayer has paid qualified adoption expenses. pp. I:14-13 and I:14-14. I:14-52 a. AOTC = 100% of first $2,000 qualified education expenses + 25% of up to next $2,000 of qualified education expenses Because the Norths’ 2014 AGI does not exceed $160,000, their AOTC will not be reduced by phaseout. Phil : 2014 Qualified education expenses = $17,350 = ($7,500 + $8,000 + $500 + $500 + $400 + $450) Tentative & Allowed AOTC = 100%($2,000) + 25%( $2,000) = $2,500 Jaci: 2014 Qualified education expenses = $3,900 = ($1,600 + $1,750 + $250 + $300) Tentative & Allowed AOTC = 100% ($2,000) + 25% ($1,900) = $2,475


Notes: For Phil and Jaci to qualify as eligible students, each must 1) not have used the AOTC for 4 prior tax years, 2) not have completed the first 4 years of postsecondary education (evaluated at beginning of 2013), 3) have been enrolled at least half-time in a degree program (or other credential), AND 4) not have been convicted of a felony drug offense (evaluated at end of tax year) Jaci appears to meet all 4 conditions. Phil appears to meet conditions 2), 3), and 4). The solution above assumes he meets condition 1) for 2014 (AOTC has not been used for Phil’s

expenses in 4 prior tax years), meaning for Spring 2014 and Fall 2014, he qualifies as an eligible student for AOTC.

If instead, the AOTC has already been used for Phil’s expenses in 4 tax years before 2014, his qualified education expenses do not qualify for the AOTC. Instead, the Lifetime Learning Credit (LLC) should be used for Phil’s 2014 qualified education expenses. LLC = 20% (qualified education expenses up to $10,000 per year) Phil: Qualified education expenses = ($7,500 + $8,000 + $500 + $500) = $16,500 Tentative LLC = 20% ($10,000) = $2,000 LLC after phaseout = $2,000 – $400 ** = $1,600

**LLC Phaseout: $2,000*($112,000 - $108,000)/$20,000 = $400

a IRC Section 25A(b)(2)(C), IRC Section 25A(i)(2), and Reg. Section 1.25A-3(d)(1)(iii) consistently indicate evaluation of whether a student has completed four years of study should occur at the beginning of the tax year. Example 2 in IRS Publication 970 (dated 3/21/2012) characterizes as an eligible student one who was considered a second-semester senior for the 2011 spring semester and a first semester graduate student in the 2011 fall semester. The example indicates the qualified education expenses for both spring and fall semesters in 2011 are eligible for the AOTC in 2011.

b. Phil’s qualified education expenses must be reduced by the scholarship ($17,350-2($3,000) = $11,350). His expenses remain high enough to yield the maximum tentative AOTC (and tentative LLC if – as described in part a – he has already used AOTC in 4 prior tax years). Tentative AOTC = 100%($2,000) + 25%( $2,000) = $2,500 Tentative LLC = 20%($10,000) = $2,000 LLC after phaseout = $2,000 - $400 = $1,600 c. With AGI of $175,000, phaseout will reduce the AOTC allowed for the Greens. Combined tentative AOTC = $2,500 + $2,475 = $4,975 Allowed AOTC = $4,975 - $4,975[($175,000 - $160,000)/$20,000] = $1,244


d. The answer would have been the same. Phil’s status as a qualified student for AOTC is based on his progress as a student at the beginning of each tax year. In both scenarios – with Phil as a junior and as a senior – Phil has not completed the first four years of postsecondary education. pp. I:14-14 through I:14-16. I:14-53 a. Tentative Tax credit:

Initial ceiling amount Minus: Nontaxable social security benefits Minus: One-half of AGI in excess of $7,500 (0.50 x [$8,500 - $7,500]) Credit base Times: Rate Total credit

$3,000 500

$5,000 (3,500) $1,500 x 0.15 $ 225

b. Only $200 of Caroline’s $225 tentative tax credit is allowed because it cannot exceed her $200 pre-credit tax liability. pp. I:14-12 to I:14-13. I:14-54 a. Net Income Tax Net Regular Tax

Regular tax before credits $37,500 Alternative minimum tax 0 Foreign tax credit (4,500) Other nonrefundable credits (6,100) Net income tax (NIT): $ 26,900 Net regular tax (NRT):

$ 37,500 n/a (4,500) (6,100) $ 26,900

The general business credit cannot exceed the smaller of 1. (NIT - tentative minimum tax) = $26,900 - $20,200 = $6,700 2. [NIT – 0.25 x (NRT - $25,000)] = $26,900 - 0.25 x (26,900 - 25,000) = $26,425 The current year general business credit is limited to $6,700. b. Mark’s current year credit will be $33,000, including $3,000 from the carryforward credit and $30,000 from the credit earned in the current year. Its use is limited to $6,700. c. Mark will carry forward to next year the $26,300 ($33,000 − $6,700) of unused credits. pp. I:14-22 to I:14-23. I:14-55 Laser's foreign tax credit of $74,000 is limited to $62,900 [($185,000/$505,000) x $171,700], because the effective foreign tax rate (40%) exceeds the effective U.S. tax rate (34%). The $11,100 ($74,000 - $62,900) unused foreign tax credit is carried back one year and forward for ten years. pp. I:14-18 and I:14-19.


I:14-56 The affordable premium amount for the Walls is set at 9.5% of the 2014 household income: 9.5%($47,200) = $4,484. The benchmark plan costs $5,616. Maximum premium tax credit = $1,132 ($5,616 - $4,484). a. Under a Gold plan, the Walls’ personal share of their health insurance premiums equals $5,888 ($7,020 – $1,132). b. Under the Silver plan, the Walls’ personal share of their health insurance premiums equals $4,484 ($5,616 – $1,132). c. Under a Bronze plan, the Walls’ personal share of health insurance premiums $3,548 ($4,680 - $1,132) pp. I:14-24 to I:14-26. I:14-57 a. The $40,000 expenditures qualify for the credit because they renovate a historic structure; they exceed the larger of the property’s basis ($20,000) or ($5,000; and the structure is used in Bob’s business. The rehabilitation tax credit is $8,000 (0.20 x $40,000). b. The building’s basis is $52,000 [$20,000 building costs + ($40,000 renovation costs - $8,000 tax credit)]. p. I:14-20. c. Straight-line depreciation must be used for the $32,000 in basis from the renovation costs. Though regular MACRS depreciation rules apply to the $20,000 basis that is not eligible for the credit, nonresidential real estate must be depreciated using straight-line over 39 years.

4.5months(20,000 32,000) /39yrs $50012months+ × =

pp. I:14-19 to I:14-20. I:14-58 Pharm, Inc. may claim a credit for research activities in the current year as follows: Regular Research Credit: Salaries $180,000 Supplies and materials 162,000 Depreciation 30,000 Total qualified research expenses $372,000 Base amount: greater of 1) 3% ($5,000,000) 2) 50% ($372,000) ( 186,000) Excess $186,000 Credit percentage x 0.20 Regular research credit $ 37,200


Pharm, Inc. would also be entitled to a research and experimentation deduction of $334,800 (Sec. 174). Research expenses for the regular research credit $372,000 Less research credit ( 37,200) Deduction allowed for current year $334,800 pp. I:14-21 and I:14-22. I:14-59 a. Carolyn’s tentative earned income credit (EIC) is $3,305 (0.34 x $9,720). b. Carolyn’s allowable EIC is $3,278 (3,305 - 27). Her earned income credit is partially phased out because her AGI of $18,000 exceeds the phaseout floor. The phaseout is $27 [0.1598 x ($18,000 - $17,830)]. c. Yes. The EIC is refundable. d. If Carolyn is married filing a joint return, the tentative EIC remains $3,305, but the phaseout is $0 because neither AGI ($18,000) nor earned income ($12,000) exceeds the phaseout floor of $23,260. pp. I:14-25 and I:14-26. I:14-60 a. $496 (0.0765 x $6,480) b. $466 [$496 - 0.0765($8,500 - $8,110)]. c. Yes, because the earned income credit is refundable. d. Yes. Jose would not be entitled to the earned income credit because his investment income exceeds $3,300. pp. I:14-23 and I:14-24. I:14-61 1. Latisha’s taxable income is $1,450 ($22,400 - 3($3,950) - $9,100). Regular tax before credits is $145 ($1,450 x 0.10). 2. The tentative EIC is $5,460 (0.40 x $13,650). The allowable credit is $4,498 ($5,460 - $962). The phaseout is $962

(0.2106 x ($22,400 - $17,830)). 3. Latisha’s refund will be $6,353.

Regular tax before credits $ 145 Regular child tax credit (145) Additional child tax credit (1,855) Earned income credit (4,498) Tax due (refund) $(6,353) pp. I:14-23 and I:14-24. I:14-62 a. It is vital that the corporation forward FICA and withholding payments to the IRS. Penalties must be imposed if Lake fails to pay these amounts to the IRS. b. The liability for payment can extend beyond the corporation. Responsible individuals such as the treasurer, in this case, can be held personally liable for payment of the tax.


p. I:14-27 (see Footnote 53). I:14-63 Wages for household employees (a), independent contractors (not employees) (b), and tips under $20 per month (g) are exempt from withholding. Only newspaper carriers (c) under age 18 are exempt. p. I:14-27. I:14-64 a. Barry may not claim exempt status since he was required to pay taxes last year. b. Barry may not claim more than one exemption. Additional withholding allowances are allowed if an individual has an unusually large amount of deductions from adjusted gross income, alimony deductions or tax credits. p. I:14-27. I:14-65 a. Bart may claim 8 withholding allowances, as follows: Bart, Jane, additional special withholding allowance (spouse unemployed), two children, and three withholding allowances connected with Bart's alimony payments. b. The monthly withholding is $246.33 per the wage bracket table for the year 2014. c. There are no special disclosure procedures. Previously, employers had to forward the Form W-4 to the IRS if the taxpayer claimed more than 10 allowances, but that requirement has been eliminated. p. I:14-30. I:14-66 a. No. Anna is not subject to the underpayment penalty because her current year withholdings ($18,200) exceed 100% of her tax liability for the previous year ($18,000). The 100% exception applies because her AGI for the prior year was not more than $150,000. b. Yes. Anna is subject to the underpayment penalty because her current year withholdings ($15,000) are less than 100% of last year's tax liability ($18,000), and also less than $27,000 (90% of this year's $30,000 tax liability). c. No. Though the underpayment penalty is based on the federal short-term interest rate plus 3%, the penalty is not deductible as interest. p. I:14-31. I:14-67 Jane is subject to the underpayment penalty because her $26,000 in current year prepayments (withholding of $12,000 plus $14,000 estimated tax payments) are less than both 110% of last year's tax liability (110% x $25,000 = $27,500) and 90% of this year's tax liability (90% x $30,000 = $27,000). She must meet the 110% exception instead of the 100% exception because her prior year AGI was more than $150,000. p. I:14-31.


Comprehensive Problem

I:14-68 a. Salary $150,000 Consulting practice net income $53,000 Novelty business net loss (18,000) 35,000 Interest income 3,000 Qualified dividend income 9,000 Long-term capital gain 24,000 Short-term capital loss ( 4,000) 20,000 ½ of self-employment tax (469)a

AGI $ 216,531 Personal exemptions (4 x $3,950) with no phaseout given AGI <$300,000 (15,800) Itemized deductions: State and local taxes 14,000 Real estate taxes 5,000 Home mortgage interest 10,000 Charitable contributions 8,000 Total 37,000 No Phaseout given AGI <$300,000 (37,000) = Taxable income $ 163,731 Tax on dividends and net LTCG ($29,000 x 0.15) $ 4,350 Tax on balance of taxable income ($134,731) $25,396

Total Tax $29,746 Less nonrefundable credits: Child tax credit $ 0b Child and dependent care credit 600c (600) $29,146 Self-employment tax 937a Total taxes $ 30,083

a SE Tax: $35,000 x 0.9235 = $32,323 net earnings from self-employment. Medicare tax = 32,323 x 0.029 = 937 Social Security tax = 0 because Mike’s salary exceeds the $117,000 ceiling on the imposition of the Social Security tax. A deduction for AGI of ½ ($937) is allowed. b The Webbs’ tentative child tax credit is $2,000 (2 × $1,000), but the phaseout [[($216,531 - $110,000) ÷ $1,000 x $50] = $5,327] eliminates the child tax credit. c The child and dependent care credit is (0.20 x $3,000 = $600). Only one child qualifies, and Nancy is deemed to have earned $250 per month, or $3,000 for the year.


b. Yes. They owe $68 in AMT. AMT Taxable Income $ 163,731 AMT Preferences 0 AMT Adjustments Itemized deductions (14,000 + 5,000) + 19,000 Personal exemptions + 15,800 AMT Income $ 198,531 Less: AMT Exemption ( 71,592) $82,100 – 25% ($198,531 – $156,500) ________

AMT Base $ 126,959 Tentative AMT# $ 29,814 Less: Regular tax ( 29,746) AMT $ 68 # Tentative AMT: 15% (29,000) + 26% (126,939 - 29,000) c. Total tax liability $ 30,751 Regular tax 29,746 SE tax 937 AMT 68 Less: Credits (600) Less: Prepayments (35,000) Withholding 21,000 Estimated payments 14,000 ________ Balance due / (refund) (4,849) d. The Webbs avoid the under payment penalty by having prepayments ($35,000) that exceed both 110% of their prior year liability and 90% of current year liability. Safe harbor 1)110% x prior year tax $29,000 = $31,900 Safe harbor 2)90% x current year tax $30,751 = $27,676


Tax Strategy Problem I:14-69 This situation involves two issues: (1) whether F&L should rent or buy, and (2) if it is better to buy, which building is the optimal choice. Rent or Buy? Given the facts, F&L’s cash flows would be better if they decided to buy rather than rent. The net out-of-pocket cost of owning equals $27,000 ($117,000 mortgage payment - $90,000 rent income) and is significantly less than the rent of $72,000 they are currently paying. Given the expected appreciation of the buildings, the buy decision is clearly superior. Building #1 or Building #2? Building #2 is the superior choice. F&L would be eligible for a 20% credit on the $600,000 of rehabilitation expenditures since the building is a certified historic structure. No credit would be available if F&L buys Building #1. It should be pointed out that much planning needs to be done with respect to Building #2 to ensure that the tax credit is allowable. Several technical requirements must be met to take the credit, such as at least 75% of the external walls and at least 75% of the building’s internal structure must remain in place. Tax Form/Return Preparation Problems I:14-70 (See Instructor’s Resource Manual) I:14-71 (See Instructor’s Resource Manual) Case Study Problems I:14-72 The following issues should be included in the client memo:

1. The IRC contains no specific penalty for failure to file quarterly estimated tax payments. There is an underpayment penalty for not paying income taxes on a timely basis, but this penalty may be avoided by paying taxes either through withholding or quarterly estimated payments.

2. An underpayment penalty will be imposed in 2014 because Barbara's

withholdings of $1,500 are not equal to at least 100% of the prior year's tax liability of $1,900. Thus, Barbara should make quarterly estimated payments of at least $100 per quarter so that her total tax prepayments for 2014 equal at least $1,900. The 100% of prior year tax liability (rather than 110%) applies because Barbara's AGI for the prior year was not in excess of $150,000.

3. From an investment income maximizing perspective, Barbara’s quarterly

estimated payments should not be more than $100 per quarter even though she will owe a considerable amount of tax when she files her 2014 return. She should invest the alimony payments, earn investment income, then pay the taxes due in


April 2015. No interest or penalties will be imposed if she prepays $1,900, meeting the safe harbor of 100% of prior year tax.

4. From a cash-flow perspective, it should be pointed out to Barbara that a sizeable tax

payment will be due on the $20,000 back alimony and $18,000 of current year alimony. She needs to be prepared to pay the remaining balance of 2014 taxes by April 15, 2015.

I:14-73 The IRS considers several factors when determining whether an individual will be classified as an employee. Revenue Ruling 87-41 provides guidance and specifies 20 factors to be considered in making this determination. The overall decision usually centers around who has the right to control the individual’s activities and time. The ruling gives examples, one of which is similar to the case at hand. The IRS would most likely rule that Simone was an employee of the corporation primarily because the corporation had control over what services she performed and had to insure that the services were performed satisfactorily. The corporation will be responsible for withholding and remitting payroll taxes for Simone. Simone will be required to file a Form W-4 with the corporation listing the number of withholding allowances. The corporation's failure to pay the employment taxes may make certain officers of the corporation liable for the payment of these taxes. Those liable are persons responsible for the accounting, collection and payment of the tax who willfully fail to do so. A corporation should uphold its ethical responsibilities in the collection and payment of employment taxes. The employer has a legal and ethical responsibility to file a W-4 for each employee and remit the appropriate taxes to the government willingly. Tax Research Problem I:14-74 Section 6672 states that "Those persons charged with the responsibility of collecting, accounting for, and paying over the tax to the government are subject to a penalty for willful failure to collect or account for the tax." "Responsible person" has been determined by the courts by considering such factors as: 1) Did the person have day to day management responsibilities? 2) Is he an officer, director, or major stockholder? 3) Was he involved and knowledgeable concerning the affairs of the corporation? 4) Did he sign checks, approve disbursements? 5) Was he or she a founder of the corporation? "Willful conduct" has been defined as the voluntary, conscious, or intentional act to prefer other creditors over the United States.

The facts in this tax research problem are based on the cited case (Ernest W. Carlson v. U.S.). In the tax research problem Carl Jones (1) was not the one who had final word on which bills should or should not be paid; (2) did not have significant or exclusive control over the company; (3) did not have a significant role in corporate decision making; (4) did not have management responsibilities; (5) was not knowledgeable concerning the affairs of the corporation except those which he was assigned; and (6) was not a founder of the corporation. In addition, he was not willfully failing to pay the taxes. Thus, Carl Jones is not subject to the penalty provisions of Sec. 6672.


However, Bruce Smith (1) was one the incorporators; (2) was authorized to sign bank checks; (3) had authority to make management decisions, and (4) was a key officer and member of the board of directors, and (5) was responsible for insuring that payroll taxes were paid. Thus, he does meet the definition of "responsible person." Furthermore, he did willfully fail to pay the taxes as evidenced by the decision to prefer other creditors to the IRS. Thus, he is liable for the penalties under Sec. 6672.

In Schiff v. U.S., the court held that Jones and Schiff were responsible for collecting and paying taxes for employees because they both were responsible persons with significant control over the corporation's finances even though they did not hold official corporate titles. The court explains that the actual mechanics of decision making instead of the absence of official title will help determine one who is a responsible person and those with significant control can be liable for willful avoidance of payment of taxes.

In Tsouprake v. U.S., the sole shareholder and chairman of the corporation did not

partake in daily management of the corporation. However, he was held liable for the penalty for failure to pay employment taxes because he was a responsible person and willfully avoided the tax payments. The court looked at his stock ownership, check-signing authority, and corporate financing ability.

In Guito, Jr. v. U.S., an officer of the corporation was a responsible party for payment

of employment taxes. He willfully did not pay the taxes and was held partly liable because he participated in major decision making, was chief policymaker, corporate boss, and held sufficient power to insure timely payments of the corporate tax liability. “What Would You Do In This Situation?” Solution Ch. I:14, p. I:14-30. Mr. Princeton is probably liable for payroll taxes on the amounts paid to the domestic workers. The issue is whether the domestic workers were employees or independent contractors. The distinction generally depends on the amount of control the employer has over the worker. The IRS has published a list of 20 factors that taxpayers should use to determine the degree of control over the workers. Since Mr. Princeton specifically provides the tasks to be performed, the workers will likely be classified as employees. The fact that a contract was signed declaring that they were to be classified as independent contractors is irrelevant in making the determination. Statement No. 6 of the Statements on Standards for Tax Services sets forth the responsibilities of CPAs in situations where the CPA is aware of an error. In this case, no payroll taxes were paid and no returns were filed. Therefore, the CPA should advise Mr. Princeton of the measures that should be taken to correct this situation. Returns should be filed to report the amounts paid as wages and appropriate payroll taxes should be paid. If Mr. Princeton refuses to file such returns, the CPA must consider whether to continue the professional relationship with Mr. Princeton.

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