Tax Chapter 8

How much is the Lifetime Learning Credit?

20% of eligible expenses up to an annual max of $10,000 (max credit of $2,000); not per child, only one

Credit Application Sequence

When taxpayer's have multiple credit types in the same year, they apply the credits against their gross tax in the following order: 1) nonrefundable personal credits; 2) business credits; and 3) refundable credits

Taxpayer Prepayments and Filing Requirements

When taxpayers do not pay enough taxes during the tax year or when they are late filing their tax return or late paying their taxes due, they may be subject to certain penalties.

What form do independent contractors use?

Form 1099 received from each client reporting the gross income they received from the client during the year (v employees who receive a W-2)

*What is the form that underpayment penalty is calculated on?

Form 2210

*What is the form that AMT is computed on?

Form 6251

Three Types of Tax Credits

Refundable and Nonrefundable or Business Credits

Amount of EIC

depends on the taxpayers filing status, number of qualifying children who live in the home for more than half the year, and the amount of the taxpayers earned income; . Thee credit is computed by multiplying the appropriate credit percentage times the taxpayer's earned income up to a maximum amount. The credit percentage depends upon the number of qualifying children in the home and is subject to a phase-out based upon AGI (or earned income if greater). As summarized in Exhibit 8-11, the earned income credit increases as taxpayers receive earned income up to the maximum amount of earned income eligible for the credit. However, as taxpayers earn more income, the credit begins to phase out and is completely eliminated once taxpayers earned income reaches established levels.

Refundable Personal Credits

earned income credit, foreign tax credit

Medicare Tax

helps pay medical costs for qualifying individuals

Independent Contractors and Fringe Benefits

independent contractors are not eligible for nontaxable fringe benefits (heath insurance and retirement)

AMT

tax is based on an alternative tax base meant to more closely reflect economic income than regular income tax base; to computer their AMT, taxpayers must first computer their regular income tax liability, then compute the AMT base and multiply the base by the applicable alternative tax rate; you must pay the AMT ONLY when the AMT base exceeds regular tax liability

Can taxpayers deduct the employer portion of self-employment taxes?

taxpayers can deduct the EMPLOYER portion of self employment taxes as a FOR AGI deduction

Qualifying Person for Child and Dependent Care credit

(1) a dependent under the age 13 and (2) a dependent or spouse who is physically or mentally incapable of caring for themselves and who lives in the taxpayers home for more than half the year

Employee v Independent Contractor Tax Implications

(1) the amount of their FICA taxes payable and (2) the deductibility of their business expenses

The amount of expenditures eligible for the Child and Dependent Care credit is least of what three amounts?

(1) the total amount of dependent care expenditures for the year (2) 3,000 for one qualifying persons or $6,000 for two or more persons (3) the taxpayer's earned income including wage, salary, or other taxable employee compensation, and net earnings from self employment

Tax Bracket

A tax rate schedule is composed of several ranges of income taxed at different (increasing) rates. Each separate range of income subject to a different tax rate is referred to as a tax bracket. While each filing status has its own tax rate schedule (married filing jointly and qualifying widow or widower use the same rate schedule), all tax rate schedules consist of tax brackets taxed at 10%, 12%, 22%, 24%, 32%, 35% and 37%. However, the range of income within each bracket varies by filing status.

Eligible Expenses for both AOC and Lifetime Learning Credits

Eligible expenses for both the AOC and the Lifetime Learning Credit must be reduced by scholarships received to pay for these expenses or other amounts received as reimbursements for the expenses (Pell grants, employer-sponsored reimbursement plans, Educational IRAs, 529 plans). The cost of room and board or other personal expenses do not qualify as eligible expenses for either the AOC or the Lifetime Learning Credit. For expenses that qualify for both the AOC and Lifetime Learning Credit (tuition and fees during the first four years of postsecondary education), taxpayers may choose which credit to use, but they may not claim both credits for the same student in the same year.

Tax Tables

For administrative convenience and to prevent low and middle income taxpayers from making mathematical errors using a tax rate schedule, the IRS provides tax tables for various levels of taxable income. Taxpayers with taxable income less than $100,000 generally must use the tax table to determine their tax liability. The tax tables generate nearly the same tax as calculated from the tax rate schedule.

Net Investment Income Tax

High income taxpayers are required to pay a 3.8% tax in net investment income defined as the following: (1) Gross income from interest, dividends, annuities, royalties and rents (2) Income from a trade or business that is a passive activity, or from trading financial instruments or commodities (3) net gain from disposing property (other than property in a trade or business); The tax is imposed on the lesser of: (1) net investment income or (2) the excess of modified AGI over $250,000 for MFJ and $125,000 for MFS and $200,000 for other taxpayers

Under Payment Penalties

If the taxpayer does not satisfy any of the safe harbor provisions, the taxpayer can compute the underpayment penalty owed using Form 2210. The underpayment penalty is determined by multiplying the federal short-term interest rate plus 3% by the amount of tax underpayment per quarter. The quarterly tax underpayment is the difference between the taxpayer's quarterly withholding and estimated tax payments and the required minimum tax payment under the first or second safe harbor (whichever is less). If the taxpayer does not complete Form 2210 and remit the underpayment penalty with the taxpayer's tax return, the IRS will compute and assess the penalty for the taxpayer. Note: taxpayers are not subject to underpayment penalties if: 1) had no tax liability in the previous year; or 2) the tax payable after subtracting their withholding amounts (but not estimated tax payments) is less than $1,000.

Exceptions to the Basic Tax Computation

In certain circumstances, taxpayers cannot completely determine their final tax liability from the tax rate schedule or tax table; taxpayers must perform additional computations to determine their tax liability: (1) when they recognize LT capital gains or receive dividend that are taxed at preferential (lower) rates (2) when they receive investment income subject to the net investment income tax (3) when the taxpayer is a child and the child's unearned income is taxed at the parent's marginal tax rate

Deductibility of Business Expenses Employee v Employer?

In determining the deductibility of business expenses, employees who incur unreimbursed business expenses relating to their employment cannot deduct these expenses. In contrast, self-employed independent contractors are able to deduct expenses relating to their business activities as FOR AGI deductions, which they can deduct without restriction.

Employee v Self-Employed (Independent Contractor) Determination

In its published guidance, the IRS stipulates that an employer/employee relationship exists when the party for whom the services are performed has the right to direct or control the individual performing services. To assist taxpayers in deciding whether the party receiving services has the requisite amount of control over the individual providing services, the IRS has published a list of 20 factors to consider. A few of the factors suggesting independent contractor rather than employee status include the contractor's ability to: · Set his own working hours · Work for more than one firm · Realize either a profit or loss from the activities · Perform work somewhere other than on an employer's premises · Work without frequent oversight

When are individual tax returns due?

Individual tax returns are due on April 15 for calendar year individuals (the 15th day of the fourth month following year-end). If the due date falls on a Saturday, Sunday or holiday, it is automatically extended to the next day that is not a Saturday, Sunday of holiday.

Filing Requirement

Individual taxpayers are required to file a tax return only if their gross income exceeds the applicable standard deduction amount for each of the filing statuses. With the increased standard deduction amounts starting in 2018, fewer taxpayers are now required to file tax returns. Note: a taxpayer with gross income less than the threshold may want to file a tax return to receive a refund of income taxes withheld

Why is Foreign Tax Credit a thing?

U.S. citizens must pay U.S. tax on their worldwide income. However, when they generate some or all of their income in other countries, they are required to pay income taxes to the foreign country where they earned their income. Without some form of tax relief, taxpayers earning income overseas would be double taxed on this income.

Underpayment Penalty Safe harbors

Underpayment Penalties To help taxpayers who may not be able to predict earnings for the year, the tax laws provide several safe harbor provisions.These safe harbors determine on a quarterly basis the minimum tax prepayments that a taxpayer must have to avoid the underpayment penalty. Under these provisions, taxpayers can avoid underpayment penalties if their withholdings and estimated tax payments equal or exceed one of the following two safe harbors: 1) 90% of their current tax liability; 2) 100% of their previous year tax liability (110% for taxpayers with AGI greater than $150,000).

what happens when business tax credits exceed the taxpayers gross tax for the year?

When business tax credits (other than the foreign tax credit) exceed the taxpayer's gross tax for the year, the credits are carried back 1 year and forward 20 years to use them in years when the taxpayer has sufficient gross tax liability to use the credits. Self-employed individuals may qualify for business credits.Also, individuals may be allocated business credits from flow-through entities (partnerships, LLCs and S corporations). Finally, individuals working as employees overseas or receiving dividends from investments in foreign securities may qualify for the foreign tax credit.

Child and Dependent Care credit

a tax subsidy to help taxpayers pay the cost of providing care for their dependents to allow taxpayers to work or look for work; amount of the credit is based on the amount of the taxpayers expenditures to provide care for one or more qualifying persons

American Opportunity Credit (AOC)

available for students in their first 4 years of postsecondary education; to qualify students must be enrolled in a qualifying postsecondary educational institution at least half time

Employee FICA Taxes Payable

both employees and employers have to pay FICA taxes on employee salary, wages, and other compensation paid by employers

Preferential Tax Rates for Capital Gains and Dividends

certain capital gains and certain dividends are taxed t a lower or preferential tax rate relative to other types income; preferential tax rate is 0%, 15%, or 20%; preferential rates vary with the taxpayers income (for most it is 15%)

Child Tax Credit Phase Out

child tax credit is subject to phase out based on the taxpayers AGI; phase out threshold depends on filing status: MFJ 400,000 MFS 200,000 HOH and Single 200,000

Business Tax Credits

designed to provide incentives for taxpayers to hire certain types of individuals or to participate in certain business activities; ex: Congress provides the employment tax credit to encourage businesses to hire certain unemployed individuals, and it provides the research and development credit to encourage businesses to expand funds to develop new technology; nonrefundable

Qualified Individuals under the EIC

include: (1) any individual who has at least one qualifying child (2) any individual who does not have a qualifying child for the year, but who lives int he US for more than half the year, satisfies the age requirements, and is not a dependent go another taxpayer age requirements: 25-65

Social Security Tax

intended to provide basic pension coverage for the retired and disabled

Nonrefundable Credit

may recuse a taxpayers gross tax liability to zero, but if the amount of the credit exceeds the amount of the taxpayers gross tax liability, the credit in excess of the gross tax liability is not refunded to the taxpayer and expires without ever providing tax benefits (unless the unused credit can be carried forward to a different year)

Life Time Learning Credit

nonrefundable credit the applies to the cost of tuition and fees (not books) for any course instruction to acquire or improve job skills

When does the Kiddie Tax apply?

provisions apply to a child if: (1) the cild is under 18 years old at year end (2) the child is 18 at year-end but their earned income does not exceed half of their support (3) the child is over the age of 18 at year end but under age 24 at year end and is a full time student during the year and their earned income does not exceed half of their support

Tax Credits

reduce a taxpayers tax liability dollar for dollar

Tax Decutions

reduce taxable income dollar for dollar, but the tax savings deductions generated depend on the taxpayer's marginal rate

Kiddie Tax

tax base is the child's net unearned income; net unearned income is the lesser of: (1) the child's gross unearned income minus $2,300 or (2) the child's taxable income tax does not apply unless the child has unearned income is excess of $2,300; significantly limited the tax benefit gained by a family when parents transfer income producing assets to children; if the tax applies, kids must pay tax at a higher rate

Tentative Minimum Tax and AMT Computation

taxpayers compute tentative minimum tax by multiplying the AMT base by applicable AMT rates; 2022 AMT rate schedule consists of two regular tax brackets: (1) 26% on the first $206,100 of AMT base for all taxpayers other than MFS (2) 28% on AMT base in excess of $206,100 for all taxpayers other than MFS Note: for AMT purposes long-term capital gains and dividends are taxed at the same preferential rate they were taxed for regular tax purposes (generally 0%, 15% and 20%)

Prepayments

the income tax must be paid on a pay as you go basis; This means that the tax must be prepaid via withholding from salary or through periodic estimated tax payments during the tax year. Employees pay tax through withholding while self-employed taxpayers generally pay taxes through estimated tax payments. Employers are required to withhold taxes from an employee's wages based upon the employee's 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 employees. 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 taxpayer's tax liability.

Why is the Kiddie Tax a thing?

under the assignment of income doctrine, taxpayers cannot simply assign or transfer income to other parties (earned income (income from services or labor) is taxed to the person who earns it, thus, it is difficult to shift earned income to a child); Unearned income (income form property such as dividends from stocks or interest from bonds) is taxed to owner of the property. Thus, a parent can shift unearned income to a child by transferring actual ownership of the income producing property to the child BUT by transferring ownership, the parent runs the risk that the child will sell the asset or use it in a way unintended by the parent.

Earned income under the EIC

wages, salaries, tips, and other employee compensation included in gross income and net earnings from self-employment tapers with investment income in excess of $10,300 are ineligible for the credit

Safe harbor 2: 100% of previous year liability

. The second safe harbor requires that by April 15, June 15, September 15 and January 15, the taxpayer must have paid at least 25%, 50%, 75%, and 100% of the previous year liability via withholdings or estimated tax payments to avoid the underpayment penalty

When are estimated tax payments due?

April 15, June 15, September 15, January 15 If the due date falls on a Saturday, Sunday or holiday, it is automatically extended to the next day that is not a Saturday, Sunday or holiday

Intergenerational Transfers

Because Social Security and Medicare taxes are paid by working taxpayers but received by retired taxpayers, Social Security and Medicare taxes represent intergenerational transfers

Tax Rate Schedules

Congress has constructed four different tax rate schedules for individuals; the applicable tax rate schedule is determined by the taxpayer's filing status; a taxpayer's filing status

FICA Taxes

Employees and self-employed taxpayers must pay employment (or self-employment) taxes; FICA tax consists of a Social Security and a Medicare component that are payable by both employees and employers

Employers and FICA Taxes

Employers withhold the employees FICA tax liabilities from the employee's paychecks for both the Social Security tax and the Medicare tax. Employers must also pay their portion of the Social Security tax (6.2% of employee salary or wages) and Medicare tax (1.45% of employee salary or wages). In contrast to employees, employers are not subject to the additional 0.9% Medicare tax on employee salary and wages.

What form do self-employed taxpayers report their self-employment earnings on?

Schedule C of Form 1040

Adjustments to reach AMTI

taxpayers first add back to regular taxable income the standard deduction amount (only id they deducted it in determining taxable income); other adjustments include: Plus Adjustments: (1) State Income or Sales Taxes: deductible for regular taxes purposes ($10,000 limitation) but not for AMT (2) Real Property and Personal Property Taxes: deductible for regular tax purposes ($10,000 limitation) but not for AMT Minus Adjustments: (1) State Income Tax Returns included in Regular Taxable Income: because state income taxes are deductible for AMT purposes, refunds are not taxable (2) Major Itemized Deductions that are Deductible for both Regular Tax and AMT purposes: (a) medical expenses (b) home mortgage interest expense (c) charitable contributions (d) gambling losses

Child Tax Credit

taxpayers may claim a $2,000 child tax credit for each qualifying child who is under age 17 at the end of the year and who is claimed was their dependent; must provide Childs SSN; taxpayers may also claim a $500 credit for qualifying dependents other than qualifying children (does not require SSN)

How is AMT determined

taxpayers subtract their regular tax liability from their tentative minimum tax to determine their AMT; if the taxpayers regular liability is equal to or exceeds the tentative minimum tax liability, the taxpayer does not owe any AMT

Who gets hit hardest by the AMT?

taxpayers with relatively high capital gains; the high capital gains increase AMTI, which reduces the exemption amount and thus exposes more income to AMT

What basis is the AOC on?

the AOC is applied on a per student basis; subject to phase out based on AGI (80,000-90,000 or 160,000-180,000 MFJ)

Amount of AOC

the amount of the credit is 100% of the first $2,000 of eligible expenses paid plus 25% of the next $2,000 of eligible expenses paid by the taxpayer (max for AOC is $2,500)

Alternative Minimum Taxable Income (AMTI)

to compute AMTI, taxpayers make several AMT adjustments to regular taxable income; these adjustments expand the regular income tax base to more closely reflect economic income

Eligible Expenses for AOC

tuition, fees, and other course materials (books/materials) needed for instruction at an eligible institution;

Can a taxpayer file for an extension to file?

Taxpayers unable to file a tax return by the original due date can request (by that same deadline) a 6 month extension to file, which is granted automatically by the IRS. The extension gives the taxpayer additional time to file the tax return, but does not extend the due date for paying the tax.

*Medicare Tax Rate and Limitation

The Medicare tax rate for employees is 1.45% on salary or wages up to $200,000 ($125,000 for MFS and $250,000 of combined salary or wages for MFJ) plus an additional 0.90% (2.35% in total) on salary and wages in excess of $200,000 ($125,000 for married filing separately and $250,000 of combined salary or wages for married filing jointly). There is No wage base limit for the Medicare component of FICA tax.

*Social Security Tax Rate and Wage Base Limitation

The Social tax rate for employees is 6.2% of their salary or wages (wage base is limited to $147,000 in 2022

Alternative Minimum Tax System History

The alternative minimum tax system was implemented in 1986 to ensure that taxpayers generating income pay some minimum amount of income tax each year. The tax was originally targeted at higher-income taxpayers who were benefiting from the excessive use of tax preference items such as exclusions, deferrals, and deductions to reduce or even eliminate their tax liabilities.

Calculating the Child and Dependent Care Credit

The amount of the credit is calculated by multiplying qualifying expenditures by the appropriate credit percentage. The credit percentage is based upon the taxpayer's AGI level and begins at 50% for taxpayers with AGI of $125,000 or less. For 2022, the dependent care credit is fully phased out for taxpayers with AGI over $438,000.

Marriage Penalty or Benefit

A marriage penalty occurs when a married couple incurs a greater tax liability by using the married filing jointly tax rate schedule to determine their tax on joint income that they would have owed (in total) if each spouse had used the single tax rate schedule to compute their individual incomes. The marriage penalty applies to couples with two wage earners with high incomes, but a marriage benefit applies to couples with a sole wage earner

Late Payment Penalty

An extension allows the taxpayer to delay filing a tax return but does not extend the due date for tax payments. If a taxpayer fails to pay the entire balance of tax owed by the original due date of the tax return, the tax law imposes a late payment penalty from the due date of the return until the taxpayer pays the tax. The late payment penalty equals 0.5% 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 payment and late filing (nonfraudulent) is 5% per month (25% in total). For late payment and filing due to fraud, the combined penalty for late payment and late filing is 15% per month (75% in total).

Nonrefundable Personal Credits

Congress provides many nonrefundable personal tax credits to generate tax relief for certain groups of individuals: the child tax credit provides tax relief for taxpayers who provide a home for dependent children. The child and dependent care credit provides tax relief for taxpayers who incur expenses to care for their children and other dependents in order to work. The American Opportunity Credit and the Lifetime Learning Credit help taxpayers pay for the cost of higher education.

Education Credits

Congress provides the American Opportunity Credit and the Lifetime Learning Credit to encourage taxpayers and their dependents to obtain higher education by reducing the costs of the education. Taxpayers may claim credits for eligible expenditures made by them personally, their dependents, and third parties on behalf of the taxpayer's dependents. If a student is claimed as a dependent of another taxpayer, only that taxpayer may claim the education credits (even of the dependent or another third party actually pays the education expenses). Married taxpayers filing separate returns are not eligible for the AOC or the Lifetime Learning Credit.

Employees who Work for Multiple Employer (FICA)

Employees who work for multiple employers within a calendar year may receive aggregate compensation that exceeds the Social Security wage base. Because each employer is required to withhold Social Security taxes on the employees' wages until the employee has reached the wage base limit with that employer, the employee may end up paying Social Security tax in excess of the required maximum. The IRS treats the excess Social Security tax paid through withholding as an additional federal income tax payment. The government refunds the excess withholding to the employee through either lower taxes payable with the tax return or a greater refund tax refund. In contrast, employers are not able to recover excess Social Security taxes paid on behalf of their employees.

What happens to excess of these credits and what are there orders?

Nonrefundable personal (first - lost) Business (second - carry back and carryover) Refundable Personal (last - refunded

AMT Forumla

Regular taxable income is the starting point for determining the alternative minimum tax; taxpayers make several plus and minus adjustments to regular taxable income to compute alternative minimum taxable income (AMTI). They then arrive at the AMT base by subtracting an AMT exemption from AMTI. Taxpayers multiply the AMT base by the AMT rate to determine their tentative minimum tax. Finally, to determine their alternative minimum tax, taxpayers subtract their regular tax liability from the tentative minimum tax. The alternative minimum tax is the excess of the tentative minimum tax over the regular tax. If the regular tax liability equals or exceeds the tentative minimum tax, taxpayers need not pay any AMT

What Form are individuals who are partners in a partnership and who are actively involved in the partnerships business activities required to pay self-employment taxes on the income they are allocated from the partnership?

Schedule E of Form 1040

Safe Harbor 1: 90% of current tax liability

The first safe harbor requires that by April 15, June 15, September 15 and January 15, the taxpayer must have paid at least 22.5%, 45%, 67.5%, and 90% of the current year liability via withholdings or estimated tax payments to avoid the underpayment penalty.

Late Filing Penalty

The tax law imposes a penalty on taxpayers that do not file a tax return by the required due date (the original date plus extension). The penalty equals 5% of the amount of tax owed for each month (or faction thereof) that the tax return is late, with a maximum penalty of 25%. For fraudulent failure to file, the penalty is 15% of the amount of tax owed per month with a maximum penalty of 75%. If the taxpayer owes no tax as of the due date of the tax return (plus extensions), the tax law does not impose a late filing penalty.

Why is the Credit Application Sequence Important?

This sequence maximizes the chances that taxpayers will receive full benefit for their tax credits.

AMT Exemption

To help ensure that low-income taxpayers are not required to pay the alternative minimum tax, Congress allows taxpayers to deduct an alternative minimum tax exemption amount to determine their alternative minimum tax base. The amount of the exemption depends on the taxpayer's filing status. The exemption is phased out (reduced) by 25 cents for every dollar the AMTI exceeds the threshold amount; MFJ phase out: $118,100

Foreign Tax Credit

When taxpayers pay income taxes to foreign countries, for U.S. tax purposes they may treat the payment in one of three ways: 1) under the foreign income inclusion, taxpayers may exclude $112,000 (in 2022) of 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 (subject to the $10,000 limitation on itemized tax deductions); or 3) taxpayers may include foreign income taxes in gross income and claim a foreign tax credit for the foreign taxes paid.

Self-Employment Taxes

While employees share their FICA (Social Security and Medicare) tax burden with employers, self-employed taxpayers must pay the entire FICA tax burden on their self-employment earnings; Just as it is with FICA taxes for employees, self-employment taxes consist of both Social Security and Medicare taxes. Because their FICA taxes are based on their self-employment earnings, FICA taxes for self-employment taxpayers are referred to as self-employment taxes. Just as it is with employees, the base for the Social Security component of the self-employment tax is limited to $147,000. The base for the Medicare portion of the self-employment tax is unlimited. Unlike employees, whose employer's withhold tax throughout the year on their behalf, self-employment taxpayers must satisfy their self-employment tax obligations through quarterly estimated tax payments.

Refundable Credit

a credit in excess of a taxpayers gross tax liability is refunded to the taxpayer

Earned Income Credit

a refundable credit that is 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; credit is available for qualified individuals who have earned income for the year