Chapter 8 Individual Income Tax Computation and Tax Credits Discussion Questions 1. [LO 1] What is a tax bracket? What is the relationship between filing status and the width of the tax brackets in the tax rate schedule? A tax bracket is a range of taxable income that is taxed at a specified tax rate. Because only the income in the particular range is taxed at the specified rate, tax brackets are often referred to as marginal tax brackets or marginal tax rates. The level and width of the brackets depend on the taxpayer’s filing status. The tax rate schedules include seven tax rate brackets. The rates for these brackets are 10%, 12%, 22%, 24%, 32%, 35%, and 37%. In general, the tax brackets are widest for Married filing jointly (for example, more income is taxed at 10%), followed by Head of household, Single, and then Married filing separately (the brackets for Married filing separately are exactly one-half the width of the brackets for Married filing jointly, and the width of the 10%, 12%, 22%, 24% and 32% brackets for Single and Married filing separately are the same). 2. [LO 1] In 2020, for a taxpayer with $50,000 of taxable income, without doing any actual computations, which filing status do you expect to provide the lowest tax liability? Which filing status provides the highest tax liability? For a taxpayer with $50,000, the married filing jointly filing status should provide the lowest tax liability in 2020 because the MFJ tax rate schedule taxes more of this income at 10% and 12% than the other rate schedules (the 10% and 12% tax brackets are wider). Conversely, the married filing separately and the single filing statuses will generate the highest tax liability because a smaller amount of income is taxed at 10% and 12% (the 10% and 12% tax brackets are narrower) than other tax rate schedules. 3. [LO 1] What is the tax marriage penalty and when does it apply? Under what circumstances would a couple experience a tax marriage benefit? 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 spouse’s individual income. The marriage penalty applies to couples with two wage earners with high incomes while a marriage benefit applies to couples with one breadwinner. 4. [LO 1] Once they’ve computed their taxable income, how do taxpayers determine their regular tax liability? What additional steps must taxpayers take to compute their tax liability when they have preferentially taxed income? Once taxpayers have determined their taxable income, they should split the income into two portions: (1) ordinary income and (2) income taxed at preferential rates (if any), and compute tax on each portion separately. Taxpayers compute the tax on the ordinary income portion by applying the appropriate tax rate schedule (based on their filing status). For dividends and capital gains taxed at preferential tax rates, the preferential tax rate is 0 percent, 15 percent, or 20 percent. The preferential tax rates vary with the taxpayer’s filing status and income as determined by tax brackets specific for preferential income. See Appendix D for the tax brackets by filing status that apply to preferentially taxed capital gains and dividends. A taxpayer’s total regular income tax liability is the sum of the tax on ordinary income and the tax on preferentially taxed income. 5. [LO 1] {Research} Are there circumstances in which preferentially taxed income (long-term capital gains and qualified dividends) is taxed at the same rate as ordinary income? Explain. Generally, no. This is why we refer to the income as preferentially taxed income. However, 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 taxpayer’s marginal ordinary rate unless the ordinary rate exceeds the maximum rate. Then these gains are taxed at the maximum rate. See §1(h)(1). 6. [LO 1] Augustana received $100,000 of qualified dividends this year. Under what circumstances might the entire $100,000 of income not be taxed at the same rate? The qualified dividend will be taxed at different rates if the amount of Augustana’s taxable income including the dividend (e.g., $500,000) falls within a different preferential tax bracket than her taxable income excluding the dividend (e.g., $400,000). In this scenario, part of qualified dividends will be taxed at 20% and part will would be taxed at 15%. 7. [LO 1] What is the difference between earned and unearned income? 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. 8. [LO 1] What is the kiddie tax? Explain. The kiddie tax is a tax using the parent’s marginal tax rate on the child’s unearned income in excess of $2,200. 9. [LO 1] Does the kiddie tax eliminate the tax benefits gained by a family when parents transfer income-producing assets to children? Explain. No. 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 income in excess of $2,200 ($1,100 standard deduction plus an additional $1,100). That is, parents can shift up to $2,200 of unearned investment income to a child without the child paying the kiddie tax 10. [LO 1] Does the kiddie tax apply to all children no matter their age? Explain. No, the kiddie tax applies to children who have net unearned income in excess of $2,200 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 don’t have earned income in excess of half of their support (excluding scholarships). 11. [LO 1] Lauren is 17 years old. She reports earned income of $3,000 and unearned income of $6,200. Is it likely that she is subject to the kiddie tax? Explain. Yes, Lauren is under age 18 at year end and her unearned income exceeds $2,200, so she is subject to the kiddie tax. Note that the kiddie tax base is the child’s net unearned income. Net unearned income is the lesser of the child’s gross unearned income minus $2,200 or the child’s taxable income. In this case, Lauren’s taxable income is calculated as $9,200 gross income less her standard deduction of $3,350= $5,850. Her gross unearned income minus $2,200 is calculated as $6,200 less $2,200 = $4,000, which would be taxed at her parents’ marginal tax rate. The remaining $1,850 would be taxed Lauren’s regular tax rate of 10%. 12. [LO 2] In very general terms, how is the alternative minimum tax system different from the regular income tax system? How is it similar? The AMT system is different in that it taxes a more broad or inclusive tax base than the regular income 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 regular tax purposes are not deductible for AMT purposes. Further, certain types of income included in the AMT base are not included in the regular income tax base. Also, the AMT rates are different from those for the regular income tax. The AMT system is similar to the regular tax system in that the starting point for computing the AMT tax base is regular taxable income. The AMT system is also an income tax system that allows certain deductions from the income tax base. 13. [LO 2] Describe, in general terms, why Congress implemented the AMT. 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. 14. [LO 2] Do taxpayers always add back the standard deduction when computing alternative minimum taxable income? Explain. No. Taxpayers add back the standard deduction only if they deducted it when computing their regular taxable income (that is, they add it back when they did not itemize deductions). 15. [LO 2] The starting point for computing alternative minimum taxable income is regular taxable income. What are some of the plus adjustments, plus or minus adjustments, and minus adjustments to regular taxable income to compute alternative minimum taxable income? Taxpayers first add back to regular taxable income the standard deduction amount, but only if they deducted it in determining taxable income. Taxpayers are then required to make several adjustments to compute AMTI. Exhibit 8-3 describes the most common of these adjustments. See Exhibit 8-3 from the chapter as follows: Exhibit 8-3 Common AMT adjustments Adjustment Description Plus adjustments: Tax exempt interest from private activity bonds 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. Taxpayers do not personally make the determination of whether a bond is a private activity bond. Instead, interest from private activity bonds is denoted as such on Form 1099 that taxpayers receive. Real property and personal property taxes deducted as itemized deductions Deductible for regular tax purposes (subject to $10,000 limitation for state and local tax deductions), but not for AMT purposes. State income or sales taxes Deductible for regular tax purposes (subject to $10,000 limitation for state and local tax deductions), but not for AMT purposes. Plus or Minus adjustment: Depreciation 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. Minus adjustments: State income tax refunds included in regular taxable income 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 assets Due to differences in regular tax and AMT depreciation 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. 16. [LO 2]. Describe what the AMT exemption is and who is and isn’t allowed to deduct the exemption. How is it similar to the standard deduction and how is it dissimilar? The AMT exemption ensures that most taxpayers aren’t subject to the AMT. The amount of the exemption is subject to the taxpayer’s filing status (see Exhibit 8-5 for 2020 exemption amounts) and is available to all taxpayers. Like the standard deduction, the AMT exemption reduces the taxpayer’s tax base. However, unlike the standard deduction, the AMT exemption is phased-out for high income taxpayers. Further, taxpayers don’t deduct the standard deduction if they itemize but taxpayers would deduct the AMT exemption amount in any circumstance (unless it was phased-out). 17. [LO 1, LO 2] How do the AMT tax rates compare to the regular income tax rates? Though both tax systems use a progressive tax rate schedule, AMT has only two stated marginal rates: 26% and 28%. In contrast, the regular tax system has stated marginal tax rates of 10%, 12%, 22%, 24%, 32%, 35%, and 37%. However, the preferential rates for long-term capital gains and qualified dividends apply to both the AMT system and the regular tax system. 18. [LO 2] Is it possible for a taxpayer who pays AMT to have a marginal tax rate higher than the stated AMT rate? Explain. Yes, taxpayers in the exemption phase-out range pay a higher marginal rate because each dollar of income decreases their exemption by 25 cents. Thus, taxpayers in the exemption phase-out range receiving one dollar of income must increase their AMT tax base by $1.25. If they are paying AMT at the stated 26% rate, their marginal tax rate is effectively 32.5% (26% x 1.25). 19. [LO 2] What is the difference between the tentative minimum tax (TMT) and the AMT? The tentative minimum tax is the AMT base multiplied by the AMT rates. The AMT is the excess of the TMT over the taxpayer’s regular tax liability for the year. Thus, taxpayers only pay AMT to the extent their TMT exceeds their regular tax liability. 20. [LO 3] Are an employee’s entire wages subject to the FICA tax? Explain. Employees must pay FICA taxes on their wages. This 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. The Social Security tax rate for employees is 6.2% of their salary or wages, and the Medicare tax rate for employees is 1.45%. The additional Medicare tax rate is .9% on salary or wages in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). The wage base on which Social Security taxes are paid is limited to an annually determined amount. The 2020 limit is $137,700. Because there is no wage base for the Medicare component of the FICA tax, a taxpayer’s entire wages will be subject to this portion of the FICA tax. 21. [LO 3] Bobbie works as an employee for Altron Corp. for the first half of the year and for Betel Inc. for rest of the year. She is relatively well paid. What FICA tax issues is she likely to encounter? What FICA tax issues do Altron Corp. and Betel Inc. need to consider? Because Bobbie is well paid, it is likely that her wages for the year exceed the wage base for the Social Security component of the FICA tax. However, because she worked for two employers, each employer is required to withhold Social Security taxes from her paycheck until she exceeds the wage base with that particular employer. Consequently, it is likely that Bobbie will have more Social Security taxes withheld than she actually owes. She will be able to get this excess back when she files her form 1040 for the year. The excess Social Security tax paid is treated as a tax payment or credit by Bobbie that can be applied to offset her regular tax liability (and any other tax liability) and also generate a refund. Bobbie will also need to use Form 8959 to determine her liability for the additional Medicare tax. Both Altron and Betel will withhold the Medicare tax at a rate of 1.45% on her salary or wages and the additional Medicare tax at a rate of .9% for any salary or wages above $200,000. Bobbie will report the additional Medicare tax withheld as a tax payment on Form 1040. From the employer’s perspective, both Altron and Betel must match Bobbie’s Social Security payments until Bobbie exceeds the wage base with compensation from that particular company. In this situation, as noted, it appears that Bobbie will overpay her Social Security tax. However, while Bobbie gets the excess payment back, neither Altron nor Betel gets a refund for overpaying the employer’s portion of Social Security taxes on Bobbie’s behalf because each company paid proper tax for the amount Bobbie earned from each of them. 22. [LO 3] Compare and contrast an employee’s FICA tax payment responsibilities with those of a self-employed taxpayer. Employees must pay FICA taxes on their wages. This 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 qualifying individuals. The Social Security tax rate for employees is 6.2% of their salary or wages, the Medicare tax rate for employees is 1.45% of salary or wages, and the additional Medicare tax rate is .9% of salary or wages in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). The wage base on which Social Security taxes are paid is limited to an annually determined amount. The 2020 limit is $137,700. While employees share their FICA tax burden with employers, self-employed taxpayers must pay the entire FICA tax burden on their self-employment earnings. Self-employed earnings equal 92.35% of net schedule C income. Just as it is with FICA taxes for employees, self-employed taxpayers are subject to both Social Security and Medicare taxes, and the base for the Social Security tax is limited to $137,700. The Social Security tax rate for self-employed taxpayers is 12.4% (6.2% employer share + 6.2% employee share). The Medicare tax rate for self-employed taxpayers is 2.9% on the taxpayer’s self-employment income (1.45% employer share + 1.45% employee share). The additional Medicare tax is .9% of the taxpayer’s self-employment income in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). Finally, 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. 23. [LO 3] When a taxpayer works as an employee and as a self-employed independent contractor during the year, how does the taxpayer determine her employment and self-employment taxes payable? When a taxpayer earns employee compensation and generates self-employment income in the same year, the taxpayer first pays Social Security tax on the employee compensation (up to the limit or wage base) at 6.2% and then the taxpayer pays Social Security tax (up to the limit after taking the employee compensation into account) at 12.4%. The full amount of both the salary and net self-employment income are subject to the Medicare tax. 24. [LO 3] What are the primary factors to consider when deciding whether a worker should be considered an employee or a self-employed taxpayer for tax purposes? In Rev. Rul. 87-41, 1987-1 CB 296, the IRS published a list of 20 factors to be considered when 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. Note that each factor is presented as though all other factors are held constant. 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 employer’s 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. Note that these are only a few of all the possible factors to be considered. The determination is not made by adding the number of factors for each classification. Rather, the factors should be considered together in making the contractor – employee determination. 25. [LO 3] How do the tax consequences of being an employee differ from those of being self-employed? From the worker’s perspective, 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. In contrast, business expenses incurred by employees are not deductible. While these factors appear to favor independent contractor status over employee status, employees generally don’t incur many unreimbursed expenses relating to their employment. Thus, even though independent contractors may be able to deduct more expenses than employees, they typically incur more costs in doing business. The primary tax cost for the person classified as an independent contractor rather than an employee is the payment of FICA taxes. Unlike independent contractors, employees share their FICA tax burden with employers. In contrast, self-employed taxpayers must pay the entire FICA tax burden on their self-employment earnings. Self-employed earnings equal 92.35% of net schedule C income. Just as it is with FICA taxes for employees, self-employed taxpayers are subject to both Social Security and Medicare taxes, and the base for the Social Security component of the self-employment tax is limited to $137,700. The Social Security tax rate for self-employed taxpayers is 12.4% (6.2% employer share + 6.2% employee share). The Medicare tax rate for self-employed taxpayers is 2.9% (1.45% employer share + 1.45% employee share). The additional Medicare tax rate for self-employed taxpayers is .9% on the taxpayer’s self-employment income in excess of $200,000 ($125,000 for married filing separate; $250,000 of combined salary or wages for married filing joint). Contractors are allowed to deduct the employer portion of the self-employment (FICA) taxes they pay. This helps reduce the tax sting a little. Also, because independent contractors are not employees of the company, they are responsible for paying their own estimated taxes. 26. [LO 3] {Planning} Mike wanted to work for a CPA firm, but he also wanted to work on his father’s farm in Montana. Because the CPA firm wanted Mike to be happy, it offered to let him work for the firm as an independent contractor during the fall and winter and return to Montana to work for his father during the spring and summer. He was very excited to hear that the firm was also going to give him a 5 percent higher “salary” for the six months he would be working for the firm over what he would have made over the same six-month period if he worked full time as an employee (i.e., an increase from $30,000 to $31,500). Should Mike be excited about his 5 percent raise? Why or why not? What counter offer could Mike reasonably suggest? This offer may not be as great of a deal as it sounds for Mike. While Mike is getting a 5% higher salary as an independent contractor, he will be responsible for paying his full FICA tax. Assuming Mike’s pay is under the Social Security cap, Mike will be required to pay 6.48% more in Social Security taxes than he would have had to pay as an employee [i.e., (15.3% x .9235) - 7.65%]. Mike is also allowed to deduct the employer share of his self-employment taxes as a “for” AGI deduction. This reduces the difference a little. Given Mike’s likely marginal tax rate for federal income tax purposes, the Social Security taxes alone means that Mike would have done better as an employee. Further, as a contractor, Mike is not eligible for other benefits available to employees like health insurance, life insurance, and retirement savings contributions. Thus, Mike’s 5% higher salary should not necessarily be cause for excitement. Note, however, as an independent contractor, he may be able to deduct premiums for health insurance and retirement savings contributions as “for” AGI deductions. Further, Mike has more control over his schedule as an independent contractor and he is able to do the things he wants to do. These attributes should offset some of the disadvantage of independent contractor status. An appropriate counter offer for Mike should take into account the full difference in FICA taxes he will pay as an independent contractor as well as the benefits that he will be foregoing as an independent contractor. 27. [LO 4] How are tax credits and tax deductions similar? How are they dissimilar? A tax credit and a tax deduction both reduce a taxpayer’s taxes payable. However, a credit is more valuable than a deduction. Though a deduction reduces taxable income, a tax credit reduces the taxes payable dollar-for-dollar. 28. [LO 4] What are the three types of tax credits? Explain why it is important to distinguish between the different types of tax credits. Tax credits are generally classified into one of three categories: nonrefundable personal, refundable personal, or 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 refunded. 29. [LO 4] Explain why there are such a large number and variety of tax credits. The proliferation of credits is partly because credits provide a dollar-for-dollar reduction in taxes. That is, 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 that are not easily addressed by adjustments to the tax base. Hence, credits are powerful tools for accomplishing policy objectives because they have a direct influence on the tax and the strength of the influence can be adjusted without changing the tax rate. 30. [LO 4] What is the difference between a refundable and nonrefundable tax credit? Nonrefundable credits can reduce a taxpayer’s regular tax liability and AMT liability, but cannot reduce other taxes (including self-employment taxes). Further, when a taxpayer’s nonrefundable credits exceed the sum of a taxpayer’s 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. In contrast, refundable credits can reduce a taxpayer’s regular tax liability, AMT liability, and other taxes (including self-employment taxes). If the amount of a taxpayer’s refundable credits exceeds the taxpayer’s tax liability, the taxpayer receives a refund of the excess credit. 31. [LO 4] Is the child tax credit a refundable or nonrefundable credit? Explain. The child tax credit may be either refundable or nonrefundable. The refundable portion is limited to the lesser of (1) $1,400 per each qualifying child for which the $2,000 credit is claimed, (2) the taxpayer’s earned income in excess of $2,500 times 15%, or (3) the amount of the unclaimed portion of the otherwise nonrefundable credit. If a taxpayer has enough tax liability to absorb the nonrefundable portion of the credit, the refundable portion is reduced to zero. 32. [LO 4] Diane has a job working three-quarter time. She hired her mother to take care of her two small children so Diane could work. Do Diane’s child care payments to her mother qualify for the child and dependent care credit? Explain. If Diane’s children are both dependents under the age of 13 and if her mother is not a dependent of Diane, then her payments may qualify for the child and dependent care credit. Her credit will be limited to the lesser of (1) the total amount of dependent care expenditures for the year (2) $3,000 for one qualifying person or $6,000 for two or more qualifying persons and (3) the taxpayer’s earned income. 33. [LO 4] The amount of the child and dependent care credit is based on the amount of the taxpayer’s expenditures to provide care for one or more qualifying persons. Who is considered to be a qualifying person for this purpose? A qualifying person includes (1) a dependent under the age of 13 or (2) a dependent or spouse who is physically or mentally incapable of caring for herself or himself and who lives in the taxpayer’s home for more than half the year. 34. [LO 4] Compare and contrast the lifetime learning credit with the American opportunity tax credit. The credits are similar in the sense that they are credits for postsecondary education. Also, a taxpayer may claim either credit for qualifying expenditures they make on behalf of the taxpayer, spouse, or dependent of the taxpayer. Both credits are phased-out based on AGI and both credits are at least partially nonrefundable. The credits are different in the sense that qualifying expenditures for the American opportunity tax credit (AOTC) include tuition, fees, and required course materials (including books) while qualifying expenditures for the lifetime learning credit includes tuition and fees but not required course materials. Further, the AOTC applies only to the first four years of postsecondary education while the lifetime learning credit has no such restriction. Also, 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) while the lifetime learning credit limit is a per taxpayer credit (the taxpayer may claim only one credit per year). The maximum AOTC (per student) for a year is $2,500 while the maximum lifetime learning credit for a taxpayer is $2,000. Finally, the AOTC phases out at higher levels of AGI than the lifetime learning credit and 40% of the otherwise allowable AOTC is refundable while the entire lifetime learning credit is nonrefundable. 35. [LO 4] {Research} Jennie’s grandfather paid her tuition this fall to State University (an eligible educational institution). Jennie is claimed as a dependent by her parents, but she also files her own tax return. Can Jennie claim an education credit for the tuition paid by her grandfather? What difference would it make, if any, if Jennie did not qualify as a dependent of her parents (or anyone else)? Jennie may not claim the credit for herself if she is claimed as a dependent by her parents. Under Reg. §1.25A-5(b)(3) ex. 1 for purposes of claiming the education credit on her return, a granddaughter is treated as receiving the money from her grandparent and, in turn, paying her own qualified tuition and related expenses. However, under §25A(g)(3), amounts paid by Jennie are treated as though they were made by her parents. So, her parents may claim the credit but not Jennie. If Jennie was not a dependent of another taxpayer, she would be able to claim the credit. 36. [LO 4] Why is the earned income credit referred to as a negative income tax? 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 and to encourage lower-income taxpayers to seek employment. Because it is refundable (if the credit exceeds the tax after considering nonrefundable credits the taxpayer receives a refund for the excess), it is sometimes referred to as a negative income tax. 37. [LO 4] Under what circumstances can a college student qualify for the earned income credit? 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. 38. [LO 4] How are business credits similar to personal credits? How are they dissimilar? Credits for businesses and for individuals are both designed to encourage or reward certain behavior and they both reduce taxes payable dollar-for-dollar. However, business credits are not refundable while certain personal credits are refundable. Though business credits are not refundable, tax laws allow unused credits to be carried back one year and forward 20 years for use when the taxpayer has sufficient tax liability to use the credit. Nonrefundable personal credits do not receive the same advantage and are lost if not used in the year incurred unless the unused credit can be carried to a different tax year. 39. [LO 4] When a U.S. taxpayer pays income taxes to a foreign government, what options does the taxpayer have when determining how to treat the expenditure on her U.S. individual income tax return? A U.S. taxpayer has three options in determining how to treat foreign tax payments: (1) the taxpayer may exclude the foreign earned income from U.S. taxation (subject to certain restrictions and limits) in which case the taxpayer would not deduct or receive a credit for any foreign taxes paid, (2) the taxpayer may include the foreign income in their gross income and deduct the foreign taxes paid as an itemized deduction, or (3) the taxpayer may include foreign income in gross income and claim a foreign tax credit for the foreign taxes paid. 40. [LO 4] Describe the order in which different types of tax credits are applied to reduce a taxpayer’s tax liability. When taxpayers 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. This sequence maximizes the chances that taxpayers will receive full benefit for their tax credits. 41. [LO 5] Describe the two methods that taxpayers use to prepay their taxes. 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 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 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 taxpayer’s 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 (unless those dates fall on a weekend or holiday in which case they are each due on the next business day). 42. [LO 5] What are the consequences of a taxpayer underpaying his or her tax liability throughout the year? Explain the safe-harbor provisions that may apply in this situation. If taxpayers fall behind on their tax prepayments, they may be subject to an underpayment penalty. Taxpayers can avoid an underpayment penalty if their tax withholding and estimated tax payments equal or exceed one of the following two safe harbors: (1) 90 percent of their current tax liability, or (2) 100 percent of their previous year tax liability (110 percent for individuals with AGI greater than $150,000) These two safe harbors determine on a quarterly basis the minimum tax prepayments that a taxpayer must have made to avoid the underpayment penalty. The first safe harbor requires that a taxpayer must have paid at least 22.5 percent (90 percent / 4 = 22.5 percent) of the current year liability via withholdings or estimated tax payments by April 15th to avoid the underpayment penalty for the first quarter. Similarly, by June 15th, September 15th, and January 15th, the taxpayer must have paid 45 percent (22.5 percent x 2), 67.5 percent (22.5 percent x 3), and 90 percent (22.5 percent x 4), respectively, of the current year liability via tax withholding or estimated tax payments to avoid the underpayment penalty in the second, third, and fourth quarters. The second safe harbor requires that by April 15th, June 15th, September 15th, and January 15th, the taxpayer must have paid 25 percent, 50 percent (25 percent x 2), 75 percent (25 percent x 3), and 100 percent (25 percent x 4), respectively, of the previous year liability via tax withholding by the employer or estimated tax payments by the taxpayer to avoid the underpayment penalty in the first, second, third, and fourth quarters. In determining taxpayers’ prepayments for a quarter, income tax withheld is generally treated as having been withheld evenly through the year. In contrast, estimated tax payments are credited to the taxpayer’s account when they are remitted. 43. [LO 5] Describe how the underpayment penalty is calculated. If the taxpayer does not satisfy either of the available safe harbor provisions, the taxpayer can compute the underpayment penalty owed using Form 2210, Underpayment of Estimated Tax by Individuals, Estates, and Trusts. The underpayment penalty is determined by multiplying the federal short-term interest rate plus 3 percentage points by the amount of tax underpayment per quarter. For purposes of this computation, 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 lesser). If the taxpayer does not complete the Form 2210 and remit the underpayment penalty with the taxpayer’s tax return, the IRS will compute and assess the penalty for the taxpayer. 44. [LO 5] What determines if a taxpayer is required to file a tax return? If a taxpayer is not required to file a tax return, does this mean that the taxpayer should not file a tax return? Individual taxpayers are required to file a tax return if their gross income exceeds certain thresholds, which vary based on the taxpayer’s filing status (e.g., single, married filing jointly, etc.), age, and gross income (i.e., income before deductions). In general, the thresholds are simply the applicable standard deduction amount for the different filing statuses. 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. For example, a taxpayer with gross income less than the threshold may want to file a tax return to receive a refund of income tax withheld. Thus, there are situations in which a taxpayer should file a tax return even if it is not required. 45. [LO 5] What is the due date for individual tax returns? What extensions are available? Individual tax returns are due on April 15th for calendar year individuals (i.e., the fifteenth 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, or holiday. Taxpayers unable to file a tax return by the original due date can request (by that same deadline) a six-month extension to file (not to pay the tax), which is granted automatically by the IRS. This is done by filing form 4868, Application for Automatic Extension of Time To File U.S. Individual Income Tax Return. 46. [LO 5] Describe the consequences for failure to file a tax return and late payment of taxes owed. 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. Problems 47. [LO 1] Whitney received $75,000 of taxable income in 2020. All of the income was salary from her employer. What is her income tax liability in each of the following alternative situations? a. She files under the single filing status. Whitney has an income tax liability of $12,290. Description Amount Computation (1) Taxable income $75,000 (2) Income tax liability $12,290 (75,000 – 40,125) x 22% + 4,617.50 (see tax rate schedule for Single individuals) b. She files a joint tax return with her spouse. Together their taxable income is $75,000. Whitney has an income tax liability of $8,605. Description Amount Computation (1) Taxable income $75,000 (2) Income tax liability $8,605 (75,000 – 19,750) x 12% + 1,975 (see tax rate schedule for Married Filing Jointly) c. She is married but files a separate tax return. Her taxable income is $75,000. Whitney has an income tax liability of $12,290. Description Amount Computation (1) Taxable income $75,000 (2) Income tax liability $12,290 (75,000 – 40,125) x 22% + 4,617.50 (see tax rate schedule for Married Filing Separately) d. She files as a head of household. Whitney has an income tax liability of $10,848. Description Amount Computation (1) Taxable income $75,000 (2) Income tax liability $10,848 (75,000 – 53,700) x 22% + 6,162 (see tax rate schedule for Head of Household) 48. [LO 1] In 2020, Lisa and Fred, a married couple, have taxable income of $300,000. If they were to file separate tax returns, Lisa would have reported taxable income of $125,000 and Fred would have reported taxable income of $175,000. What is the couple’s marriage penalty or benefit? The couple would have a marriage benefit of $936. That is, they pay $936 less in taxes by filing jointly than their combined tax liability if they each had filed as a single taxpayer. 2020 Marriage penalty or (benefit) Two income vs. Single income married couple Married couple Taxable income Tax if file Jointly (1) Tax if file Single (2) Marriage penalty (benefit) (1) – (2) Wife (Lisa) $125,000 $24,079.50† Husband (Fred) 175,000 37,015.50‡ Combined $300,000 $60,159* $61,095 ($936) *$29,211 + [(300,000 – 171,050) × .24] †$14,605.50 + [(125,000 – 85,525) × .24] ‡$33,271.50 + [(175,000 –163,300) × .32] 49. [LO 1] In 2020, Jasmine and Thomas, a married couple, have taxable income of $150,000. If they were to file separate tax returns, Jasmine would have reported taxable income of $140,000 and Thomas would have reported taxable income of $10,000. What is the couple’s marriage penalty or benefit? The couple would have a marriage benefit of $4,102. That is, they pay $4,102 less in taxes by filing jointly than their combined tax liability if they each would have filed as single taxpayer. 2020 Marriage penalty or (benefit) Two income vs. Single income married couple Married couple Taxable income Tax if file Jointly (1) Tax if file Single (2) Marriage penalty (benefit) (1) – (2) Wife (Jasmine) $140,000 $27,679.50† Husband (Thomas) 10,000 1,002.50‡ Combined $150,000 $24,580* $28,682 $(4,102) *$9,235 + [(150,000 – 80,250) × .22] †$14,605.50 + [(140,000 – 85,525) × .24] ‡$987.50 + [(10,000 – 9,875) × .12] 50. [LO 1] Lacy is a single taxpayer. In 2020, her taxable income is $42,000. What is her tax liability in each of the following alternative situations? a. All of her income is salary from her employer. Lacy’s total tax is $5,030. Description Amount Explanation (1) Taxable income $42,000 (2) Preferentially taxed income 0 (3) Income taxed at ordinary rates 42,000 (1) – (2) (4) Tax on income taxed at ordinary rates $5,030 (42,000 – 40,125) × 22% + 4,617.50 (see tax rate schedule for Single individuals) (5) Tax on preferentially taxed income 0 Tax on taxable income $5,030 (4) + (5) b. Her $42,000 of taxable income includes $1,000 of qualified dividends. Lacy’s total tax is $4,960. Description Amount Explanation (1) Taxable income $42,000 (2) Preferentially taxed income 1,000 (3) Income taxed at ordinary rates 41,000 (1) – (2) (4) Tax on income taxed at ordinary rates 4,810 (41,000 – 40,125) × 22% + 4,617.50 (5) Tax on preferentially taxed income 150 ($42,000 -– $41,000) × 15% [The $1,000 falls in the 15% tax bracket]. Tax on taxable income $4,960 (4) + (5) c. Her $42,000 of taxable income includes $5,000 of qualified dividends. Lacy’s total tax is $4,542.50. Description Amount Explanation (1) Taxable income $42,000 (2) Preferentially taxed income 5,000 (3) Income taxed at ordinary rates 37,000 (1) – (2) (4) Tax on income taxed at ordinary rates 4,242.50 (37,000 – 9,875) × 12% + 987.50 (5) Tax on preferentially taxed income 300 ($40,000 -– $37,000) × 0% + ($42,000 – $40,000) × 15% [The first $3,000 of preferentially taxed income falls in the 0% tax bracket; the remaining $2,000 falls in the 15% tax bracket]. Tax on taxable income $4,542.50 (4) + (5) 51. [LO 1] In 2020, Sheryl is claimed as a dependent on her parent’s tax return. Her parents report taxable income of $500,000 (married filing jointly). Sheryl did not provide more than half her own support. What is Sheryl’s tax liability for the year in each of the following alternative circumstances? a. She received $7,000 from a part-time job. This was her only source of income. She is 16 years old at year-end. Sheryl’s tax liability is $0. Note that Sheryl has no unearned income and is not subject to the kiddie tax. Description Amount Explanation (1) Gross income/AGI $7,000 7,000 in wages All earned income (2) Standard deduction for dependent on another tax return (7,350) Earned income + $350 (3) Taxable income $0 (1) + (2) Total tax $0 b. She received $7,000 of interest income from corporate bonds she received several years ago. This is her only source of income. She is 16 years old at year-end. Sheryl’s tax liability is $1,790. Note that Sheryl is subject to the kiddie tax because she is under age 18 and has unearned income. Description Amount Explanation (1) Gross income/AGI (all unearned income) $7,000 $7,000 interest income (all unearned income) (2) Minimum standard deduction 1,100 Minimum for taxpayer claimed as dependent on another return (3) $350 plus earned income 350 350 + 0 earned income (4) Standard deduction for dependent on another tax return 1,100 Greater of (2) or (3) (5) Taxable income $5,900 (1) - (4) (6) Gross unearned income minus $2,200 $4,800 (1) - $2,200) (7) Net unearned income $4,800 Lesser of (5) or (6) (8) Kiddie tax 1,680 [$4,800 × 35%)], Sheryl’s parents marginal tax rate is 35%; see married filing joint tax rate schedule, $500,000 taxable income (9) Taxable income taxed at Sheryl’s tax rate $1,100 (5) – (7) (10) Sheryl’s income tax rate 10% Single filing status (11) Tax on taxable income using Sheryl’s rate $110 (9) x (10) Total tax $1,790 (8) + (11) c. She received $7,000 of interest income from corporate bonds she received several years ago. This is her only source of income. She is 20 years old at year-end and is a full-time student. Sheryl’s tax liability is $1,790. Sheryl is subject to the kiddie tax because she is a full-time student under age 24 and has unearned income. Description Amount Explanation (1) Gross income/AGI (all unearned income) $7,000 7,000 interest income (all unearned income) (2) Minimum standard deduction 1,100 Minimum for taxpayer claimed as dependent on another return (3) $350 plus earned income 350 350 + 0 earned income (4) Standard deduction for dependent on another tax return 1,100 Greater of (2) or (3) (5) Taxable income $5,900 (1) – (4) (6) Gross unearned income minus $2,200 $4,800 $7,000 interest income - $2,200 (7) Net unearned income $4,800 Lesser of (5) or 6) (8) Kiddie tax $1,680 [$4,800 × 35%)], Sheryl’s parents marginal tax rate is 35%; see married filing joint tax rate schedule, $500,000 taxable income (9) Taxable income taxed at Sheryl’s tax rate $1,100 (5) – (7) (10) Sheryl’s income tax rate 10% (11) Tax on taxable income using Sheryl’s rate $110 (9) x (10) Total tax $1,790 (8) + (11) d. She received $7,000 of qualified dividend income. This is her only source of income. She is 16 years old at year-end. Sheryl’s tax liability is $960. Note that Sheryl is subject to the kiddie tax because she is under age 18 and has unearned income. Description Amount Explanation (1) Gross income/AGI (all unearned income) $7,000 7,000 dividend income (all unearned) (2) Minimum standard deduction 1,100 Minimum for taxpayer claimed as dependent on another return (3) $350 plus earned income 350 350 + 0 earned income (4) Standard deduction for dependent on another tax return 1,100 Greater of (2) or (3) (5) Taxable income $5,900 (1) – (4) (6) Gross unearned income minus $2,200 $4,800 $7,000 dividends - $2,200 (7) Net unearned income $4,800 Lesser of (5) or (6) (8) Kiddie tax $960 [$4,800 × 20%)], Sheryl’s parents tax rates for net capital gains and qualified dividend is 20%, see tax rates for net capital gains and qualified dividends for married filing jointly, $500,000 of taxable income (9) Income taxed at Sheryl’s tax rate $1,100 (5)-(7) (10) Sheryl’s preferential rate 0% (Sheryl’s only income is taxed at a preferred rate of 0% because her taxable income falls in the 0% bracket which spans taxable income of $0 to $40,000 (11) Tax on income using Sheryl’s preferential rate 0 Total tax $960 (8) + (11) 52. [LO 1] In 2020, Carson is claimed as a dependent on his parent’s tax return. His parents report taxable income of $200,000 (married filing jointly). Carson’s parents provided most of his support. What is Carson’s tax liability for the year in each of the following alternative circumstances? a. Carson is 17 years old at year-end and earned $14,000 from his summer job and part-time job after school. This was his only source of income. Carson’s tax liability is $160. Note that Carson has no unearned income and is not subject to the kiddie tax. Description Amount Explanation (1) Gross income/AGI $14,000 14,000 in wages All earned income (2) Standard deduction (12,400) Not subject to kiddie tax limitations—no unearned income (3) Taxable income $1,600 (1) + (2) Total tax $160 1,600 × 10% (see rate schedule for Single individuals) b. Carson is 23 years old at year-end. He is a full-time student and earned $14,000 from his summer internship and part-time job. He also received $5,000 of qualified dividend income. Carson’s tax liability is $580. Carson is subject to the kiddie tax because he is a full-time student under age 24 and has unearned income greater than $2,200. Description Amount Explanation (1) Gross income/AGI (all unearned income) $19,000 14,000 earned income & $5,000 unearned income (qualified dividends) (2) Minimum standard deduction 1,100 Minimum for taxpayer claimed as dependent on another return (3) $350 plus earned income, Limited to $12,400 12,400 350 + 14,000 earned income (not to exceed $12,400 regular standard deduction) (4) Standard deduction for dependent on another tax return 12,400 Greater of (2) or (3) (5) Taxable income $6,600 (1) – (4) (6) Gross unearned income minus $2,200 2,800 $5,000 dividends - $2,200 (7) Net unearned income $2,800 Lesser of (5) or (6) (8) Kiddie tax $420 [$2,800 × 15%)], Carson’s parents tax rates for net capital gains and qualified dividend is 15%, see tax rates for net capital gains and qualified dividends for married filing jointly, $200,000 of taxable income (9) Taxable income taxed at Carson’s rate $3,800 (5) – (7) (10) Preferential income taxed at Carson’s tax rates 2,200 $5,000 Dividends – (7) (11) Tax on preferential income $0 (10) x 0% (Carson’s tax rate would be 10 percent if it were ordinary income, so he qualifies for 0 percent rate on dividends). (12) Taxable income tax at Carson’s ordinary tax rates $1,600 (9) – (10) (13) Tax on ordinary income $160 (12) x 10% Total tax $580 (8) + (11) + (13) 53. [LO 2] Brooklyn files as a head of household for 2020. She claimed the standard deduction of $18,650 for regular tax purposes. Her regular taxable income was $80,000. What is Brooklyn’s AMTI? Brooklyn has an AMTI of $98,650. The standard deduction, if taken, must be added back to regular taxable income to arrive at AMTI. Description Amount Explanation (1) Regular taxable income $80,000 (2) Standard Deduction 18,650 AMTI $98,650 (1) + (2) 54. [LO 2] Sylvester files as a single taxpayer during 2020. He itemizes deductions for regular tax purposes. He paid charitable contributions of $7,000, real estate taxes of $1,000, state income taxes of $4,000, and mortgage interest of $2,000 on $30,000 of acquisition indebtedness on his home. Sylvester’s regular taxable income is $100,000. What is Sylvester’s AMTI? Sylvester’s AMTI is $105,000. Description Amount Explanation (1)Regular taxable income $100,000 (2) Real estate and state income taxes 5,000 Real estate taxes of $1,000 + state income taxes of $4,000. State taxes are not deductible for AMT purposes. AMTI $105,000 (1)+ (2) 55. [LO 2] {Tax Forms} In 2020, Nadia has $100,000 of regular taxable income. She itemizes her deductions as follows: real property taxes of $1,500, state income taxes of $2,000, and mortgage interest expense of $10,000 (acquisition debt of $200,000). In addition, she receives tax-exempt interest of $1,000 from a municipal bond (issued in 2006) that was used to fund a new business building for a (formerly) out-of-state employer. Finally, she received a state tax refund of $300 from the prior year. a. What is Nadia’s AMTI this year if she deducted $15,000 of itemized deductions last year and did not owe any AMT last year? Complete Form 6251 (through line 4) for Nadia. Nadia’s AMTI is $104,200. Description Amount Explanation (1) Regular taxable income $100,000 (2) Interest from private activity bond 1,000 Included in AMTI because not issued in 2009 or 2010. (3) Real estate taxes 1,500 Not deductible for AMT (4) State income taxes 2,000 Not deductible for AMT (5) State tax refund (300) See note below AMTI $104,200 Sum of (1) through (5) Note: Nadia would have included the $300 refund in regular taxable income because she deducted state taxes last year as an itemized deduction for regular tax purposes. However, she was not allowed to deduct the state taxes last year for AMT purposes, and thus she is not required to include the refund in AMTI. b. What is Nadia’s AMTI this year if she deducted the standard deduction last year and she did not owe any AMT last year? Complete Form 6251 (through line 4) for Nadia. Nadia’s AMTI is $104,500. Description Amount Explanation (1) Regular taxable income $100,000 (2) Interest from private activity bond 1,000 Included in AMTI because not issued in 2009 or 2010. (3) Real estate taxes 1,500 Not deductible for AMT (4) State income taxes 2,000 Not deductible for AMT AMTI $104,500 Sum of (1) through (4) Note: Home mortgage interest expense is deductible for both regular tax and AMT purposes and thus no AMT adjustment is necessary for this item in either scenario. Also, if Nadia did not itemize last year, she was not required to include her state income tax refund in her regular taxable income this year. Thus, there is no AMT adjustment required for the state income tax refund she received this year. 56. [LO 2] {Tax Forms} In 2020, Sven is single and has $120,000 of regular taxable income. He itemizes his deductions as follows: real property tax of $2,000, state income tax of $4,000, mortgage interest expense of $15,000 (acquisition debt of $300,000). He also has a positive AMT depreciation adjustment of $500. What is Sven’s alternative minimum taxable income (AMTI)? Complete Form 6251 (through line 4) for Sven. Sven’s AMTI is $126,500. Description Amount Explanation (1) Regular taxable income $120,000 (2) Real property taxes 2,000 Not deductible for AMT (3) State income taxes 4,000 Not deductible for AMT (4) Depreciation adjustment 500 AMTI $126,500 Sum of (1) through (4) 57. [LO 2] Olga is married and files a joint tax return with her husband. What amount of AMT exemption may she deduct under the following alternative circumstances? a. Her AMTI is $390,000. Because Olga's AMTI does not exceed $1,036,800 (the threshold amount for MFJ), her AMT exemption is not phased-out, and she is entitled to the full exemption amount of $113,400. b. Her AMTI is $1,080,000. Because Olga’s AMTI exceeds $1,036,800, she must phase-out her exemption and is entitled to an exemption of $102,600. Olga’s exemption is calculated as follows: $113,400 – [(1,080,000 – 1,036,800) x 25%] = $102,600 c. Her AMTI is $1,500,000. Because Olga’s AMTI exceeds $1,036,800, she must phase-out her exemption. In this case, Olga’s exemption is reduced to $0 as follows: $113,400 – [(1,500,000 – 1,036,800) x 25%] = –2,400, limited to $0. 58. [LO 2] Corbett’s AMTI is $600,000. What is his AMT exemption under the following alternative circumstances? a. He is married and files a joint return. Because his AGI is below the $1,036,800 threshold for MFJ, his exemption is not phased out, and he is entitled to a full $113,400 exemption. b. He is married and files a separate return. Corbett’s AGI is in the phase-out range for married filing separately. His exemption amount is reduced to $36,300. $56,700 – [(600,000 – 518,400) × 25%] = $36,300 c. His filing status is single. Corbett’s AGI is in the phase-out range for single filing status. His exemption amount is reduced to $52,500. $72,900 – [(600,000 – 518,400) × 25%] = $52,500 d. His filing status is head of household. Corbett’s AGI is in the phase-out range for head of household filing status. His exemption amount is reduced to $52,500. $72,900 – [(600,000 – 518,400) × 25%] = $52,500 59. [LO 2] In 2020, Juanita is married and files a joint tax return with her husband. What is her tentative minimum tax in each of the following alternative circumstances? a. Her AMT base is $100,000, all ordinary income. Juanita’s tentative minimum tax is $26,000. Description Amount Reference (1) AMT base $100,000 (2) Dividends taxed at preferential rate 0 (3) Tax on dividends 0 (4) AMT base taxed at regular AMT rates 100,000 (1) – (2) (5) Tax on AMT base taxed at 26% rate 26,000 100,000 × 26% (6) Tax on AMT base (in excess of $197,900) taxed at 28% rate 0 Tentative minimum tax $26,000 (3) + (5) + (6) b. Her AMT base is $250,000, all ordinary income. Juanita’s tentative minimum tax is $66,042. Description Amount Reference (1) AMT base $250,000 (2) Dividends taxed at preferential rate 0 (3) Tax on dividends 0 (4) AMT base taxed at regular AMT rates 250,000 (1) – (2) (5) Tax on AMT base taxed at 26% rate 51,454 197,900 × 26% (6) Tax on AMT base (in excess of $197,900) taxed at 28% rate 14,588 (250,000 – 197,900) × 28% Tentative minimum tax $66,042 (3) + (5) + (6) c. Her AMT base is $100,000, which includes $10,000 of qualified dividends. Juanita’s tentative minimum tax is $24,900. Description Amount Reference (1) AMT base $100,000 (2) Dividends taxed at preferential rate 10,000 (3) Tax on dividends 1,500 (2) × 15%, (The entire $10,000 falls in the 15% tax bracket for preferential income, which spans taxable income of $80,001 to $496,600) (4) AMT base taxed at regular AMT rates 90,000 (1) – (2) (5) Tax on AMT base taxed at 26% rate 23,400 90,000 × 26% (6) Tax on AMT base (in excess of $197,900) taxed at 28% rate 0 Tentative minimum tax $24,900 (3) + (5) + (6) d. Her AMT base is $250,000, which includes $10,000 of qualified dividends. Juanita’s tentative minimum tax is $64,742. Description Amount Reference (1) AMT base $250,000 (2) Dividends taxed at preferential rate 10,000 (3) Tax on dividends 1,500 (2) × 15%, (The entire $10,000 falls in the 15% tax bracket for preferential income, which spans taxable income of $80,001 to $496,600) (4) AMT base taxed at regular AMT rates 240,000 (1) – (2) (5) Tax on AMT base taxed at 26% rate 51,454 197,900 × 26% (6) Tax on AMT base (in excess of $197,900) taxed at 28% rate 11,788 (240,000 – 197,900) × 28% Tentative minimum tax $64,742 (3) + (5) + (6) 60. [LO 2] Steve’s tentative minimum tax (TMT) for 2020 is $245,000. What is his AMT if a. His regular tax is $230,000? Steve’s AMT for 2020 is $15,000. Description Amount Reference (1) Tentative minimum tax $245,000 (2) Regular tax liability 230,000 Alternative minimum tax $15,000 (1) – (2) b. His regular tax is $250,000? $0. Steve does not owe any AMT because his regular tax liability is greater than his TMT. Description Amount Reference (1) Tentative minimum tax $245,000 (2) Regular tax liability 250,000 Alternative minimum tax $0 (1) – (2) [note that AMT cannot be negative] 61. [LO 2] {Tax Forms} In 2020, Janet and Ray are married filing jointly. They have five dependent children under 18 years of age. Janet and Ray’s taxable income is $2,400,000 and they itemize their deductions as follows: state income taxes of $10,000 and mortgage interest expense of $25,000 (acquisition debt of $300,000). What is Janet and Ray’s AMT? Complete Form 6251 for Janet and Ray. Janet and Ray will not owe AMT. AMT Description Amount Reference (1) Regular taxable income $2,400,000 (2) State income taxes 10,000 (3) AMTI $2,410,000 (1) + (2) (4) Full exemption 113,400 See exemption amount for MFJ (5) Phase-out of exemption 113,400 ([(3) – 1,036,800] × 25%), limited to $113,400 (6) AMT exemption 0 (4) – (5) (7) AMT base $2,410,000 (3) – (6) (8) AMT rate 26% and 28% 26% on first $197,900 of AMT base and 28% on AMT base in excess of $197,900 (9) Tentative minimum tax $670,842 $197,900 x 26% = $51,454; ($2,410,000- $197,900) x 28%= $619,388 (10) Regular tax liability 825,149 (2,400,000 – 622,050) × 37% +167,307.50 AMT $0 (9) – (10) 62. [LO 2] {Tax Forms} In 2020, Deon and NeNe are married filing jointly. Deon and NeNe’s taxable income is $1,090,000, and they itemize their deductions as follows: real property taxes of $10,000, charitable contributions of $30,000, and mortgage interest expense of $40,000 (acquisition debt of $700,000 for home). What is Deon and NeNe’s AMT? Complete Form 6251 for Deon and NeNe. Deon and NeNe will not owe AMT. AMT Description Amount Reference (1) Regular taxable income $1,090,000 (2) Real property taxes 10,000 (3) AMTI $1,100,000 (1) + (2) (4) Full exemption 113,400 See exemption amount for MFJ (5) Phase-out of exemption 15,800 [(3) – 1,036,800] × 25%, not to exceed 113,400 (6) AMT exemption 97,600 (4) - (5) (7) AMT base $1,002,400 (3) – (6) (8) AMT Rate 26% and 28% 26% on first $197,900 of AMT base and 28% on AMT base in excess of $197,900 (9) Tentative minimum tax $276,714 $197,900 x 26%= $51,454; ($1,002,400- $197,900) x 28%= $225,260 (10) Regular tax liability $340,449 (1,090,000 – 622,050) × 37% + 167,307.50 AMT 0 (9) – (10), but not less than 0 63. [LO 1] [LO 3]. Henrich is a single taxpayer. In 2020, his taxable income is $450,000. What is his income tax and net investment income tax liability in each of the following alternative scenarios? a. All of his income is salary from his employer. Henrich’s total tax is $132,295. Description Amount Explanation (1) Taxable income $450,000 (2) Preferentially taxed income 0 (3) Income taxed at ordinary rates 450,000 (1) – (2) (4) Tax on income taxed at ordinary rates $132,295 (450,000 – 207,350) × 35% + 47,367.50 (see tax rate schedule for Single individuals) (5) Tax on preferentially taxed income 0 (6) Income tax $132,295 (4) + (5) (7) Net investment income tax 0 Henrich has no investment income Total income & net investment income tax $132,295 (6) + (7) b. His $450,000 of taxable income includes $2,000 of long-term capital gain that is taxed at preferential rates. Henrich’s total tax is $132,071. Description Amount Explanation (1) Taxable income $450,000 (2) Preferentially taxed income 2,000 (3) Income taxed at ordinary rates 448,000 (1) – (2) (4) Tax on income taxed at ordinary rates 131,595 (448,000 – 207,350) × 35% + 47,367.50 (see tax rate schedule for Single individuals) (5) Tax on preferentially taxed income 400 (2) × 20% [The entire $2,000 falls in the 20% bracket that spans taxable income of $441,451+] (6) Income tax $131,995 (4) + (5) (7) Net investment income tax 76 Since Henrich’s modified AGI exceeds $200,000, the entire $2,000 long-term capital gain is subject to the 3.8% net investment income tax ($2,000 x 3.8% = $76). Total income & net investment income tax $132,071 (6) + (7) c. His $450,000 of taxable income includes $55,000 of long-term capital gain that is taxed at preferential rates. Henrich’s total tax is $123,812.50. Description Amount Explanation (1) Taxable income $450,000 (2) Preferentially taxed income 55,000 (3) Income taxed at ordinary rates 395,000 (1) – (2) (4) Tax on income taxed at ordinary rates 113,045 (395,000 – 207,350) × 35% + 47,367.50 (5) Tax on preferentially taxed income 8,677.50 (441,450 – 395,000) × 15% + (55,000 – (441,450 – 395,000)) × 20% (6) Income tax $121,722.50 (4) + (5) (7) Net investment income tax 2,090 Since Henrich’s modified AGI exceeds $200,000, the entire $55,000 long-term capital gain is subject to the 3.8% net investment income tax ($55,000 x 3.8% = $2,090). Total income & net investment income tax $123,812.50 (6) + (7) d. Now assume that Henrich has $195,000 of taxable income, which includes $50,000 of long-term capital gain that is taxed at preferential rates. Assume his modified AGI is $210,000. Henrich’s total tax is $36,759.50. Description Amount Explanation (1) Taxable income $195,000 (2) Preferentially taxed income 50,000 (3) Income taxed at ordinary rates 145,000 (1) – (2) (4) Tax on income taxed at ordinary rates 28,879.50 (145,000 – 85,525) × 24% + 14,605.50 (5) Tax on preferentially taxed income 7,500 ($50,000 × 15%) [The entire $50,000 falls in the 15% bracket that spans taxable income of $40,000 to $441,450] (6) Income tax $36,379.50 (4) + (5) (7) Net investment income tax 380 3.8% x the lesser of (a) $50,000 of net investment income or (b) ($210,000 modified AGI less $200,000 threshold) = 3.8% x $10,000 = $380. Total income & net investment income tax $36,759.50 (6) + (7) 64. [LO 3] Brooke, a single taxpayer, works for Company A for all of 2020, earning a salary of $50,000. a. What is her FICA tax obligation for the year? $3,825. Because Brooke’s salary is below the $137,700 Social Security wage base limit for 2020, she pays FICA taxes of 7.65% on her entire $50,000 ($50,000 × 7.65% = $3,825). b. Assume Brooke works for Company A for half of 2020, earning $50,000 in salary and she works for Company B for the second half of 2020, earning $90,000 in salary. What is Brooke’s FICA tax obligation for the year? In 2020, the first $137,700 of salary is subject to the 6.2% Social Security tax. This is true even though the taxpayer may work for more than one employer. In this case, Brooke earned a total salary of $140,000. Only $137,700 of this is subject to the 6.2% Social Security tax. So, Brooke must pay $8,537 (rounded) in Social Security tax. Taxpayers’ entire salary is subject to the Medicare component of the FICA tax no matter how many employers the taxpayer worked for during the year. Because her total Medicare wages do not exceed $200,000, Brooke must pay $2,030 of Medicare tax (i.e., $140,000 × 1.45%). She is not subject to the additional Medicare tax. In total, Brooke’s FICA tax obligation for the year is $10,567 consisting of $8,537 of Social Security tax and $2,030 of Medicare tax. Note, however, that both Company A and Company B will withhold the full Social Security tax as if she did not exceed the limit. In this case, Brook would end up overpaying $143 [($140,000 – 137,700) x 6.2%]. She will get a credit to offset her taxes payable for this amount when she files her tax return. 65. [LO 3] Rasheed works for Company A, earning $350,000 in salary during 2020. Assuming he is single and has no other sources of income, what amount of FICA tax will Rasheed pay for the year? For 2020, Rasheed will pay Social Security taxes of 6.2% on the first $137,700 of his salary, Medicare taxes of 1.45% on his salary, and additional Medicare taxes of .9% on $150,000 of his salary (his $350,000 salary in excess of $200,000). In total, Rasheed will pay $8,537 (rounded) of Social Security taxes (6.2% x $137,700), $5,075 of Medicare taxes ($350,000 x 1.45%), $1,350 of additional Medicare taxes for the year ($150,000 x .9%) for a total of $14,962 in FICA taxes. 66. [LO 3]. Alice is single and self-employed in 2020. Her net business profit on her Schedule C for the year is $150,000. What is her self-employment tax liability and additional Medicare tax liability for 2020? A taxpayer’s tax base for computing a self-employed taxpayer’s self-employment tax (i.e., net earnings from self-employment) is the taxpayer’s net business profit from Schedule C multiplied by 92.35%. So, Alice’s net earnings from self-employment is her net profit from Schedule C of $150,000 x 92.35% = $138,525. Alice will owe $17,075 ($137,700 maximum amount x 12.4%, rounded) in Social Security taxes and $4,017 ($138,525 x 2.9%, rounded) for the Medicare component of FICA taxes. Alice owes total self-employment tax of $21,092 ($17,075 + 4,017). She is not subject to the additional Medicare tax because her net earnings from self-employment do not exceed $200,000. 67. [LO 3] Kyle, a single taxpayer, worked as a freelance software engineer for the first three months of 2020. During that time, he earned $44,000 of self-employment income. On April 1, 2020, Kyle took a job as a full-time software engineer with one of his former clients, Hoogle Inc. From April through the end of the year, Kyle earned $178,000 in salary. What amount of FICA taxes (self-employment and employment related) does Kyle owe for the year? $12,464 of FICA taxes. When a taxpayer has both salary and self-employment income during a year, the wages are applied first in determining the amount of FICA/Self-employment taxes payable for the year. This is true even when the self-employment income is earned before the wages, as is the case in Kyle’s situation. This ordering is beneficial to Kyle. Description Amount Explanation (1) Social Security tax paid as an employee [lesser of [(a) $178,000 wages or (b) $137,700 maximum base] x 6.2% $8,537 $137,700 x 6.2%, rounded (2) Social Security wage base limit less employee compensation subject to Social Security tax $0 $137,700 - $137,700, limited to $0 (3) Net earnings from self-employment 40,634 $44,000 x 92.35% (4) Social Security portion of self-employment tax 0 Lesser of [Step (2) or (3)] × 12.4% (5) Employer portion of Medicare tax for self-employment tax purposes 589 Step (3) × 1.45% (6) Sum of taxpayer’s compensation and net earnings from self-employment 218,634 $178,000 + Step (3) (7) Employee portion of Medicare tax 3,170 (6) × 1.45% (8) Additional Medicare tax 168 (218,634-200,000) x .9% (9) Employee portion of Medicare tax 3,338 (7) + (8) Total FICA taxes owed for year 12,464 Steps (1) + (4) + (5) + (9) 68. [LO 3] Eva received $60,000 in compensation payments from JAZZ Corp. during 2020. Eva incurred $5,000 in business expenses relating to her work for JAZZ Corp. JAZZ did not reimburse Eva for any of these expenses. Eva is single and she deducts a standard deduction of $12,400. Based on these facts, answer the following questions: a. Assume that Eva is considered to be an employee. What amount of FICA taxes is she required to pay for the year? $4,590. Because Eva’s salary is below the Social Security wage base limit for 2020 of $137,700, she pays FICA taxes of 7.65% on her entire $60,000 ($60,000 × 7.65% = $4,590). b. Assume that Eva is considered to be an employee. What is her regular income tax liability for the year? $6,262 as calculated below. Description Amount Explanation (1) Salary $60,000 (2) Standard deduction (12,400) Itemized deductions less than standard deduction. (3) Taxable income $47,600 (1) + (2) Regular tax liability $6,262 (47,600 – 40,125) × 22% + 4,617.50 [see tax rate schedule for Single individuals] c. Assume that Eva is considered to be a self-employed contractor. What is her self-employment tax liability and additional Medicare tax liability for the year? $7,771 of self-employment taxes and $0 of additional Medicare taxes as calculated below. Description Amount Explanation (1) Gross self-employment compensation $60,000 (2) Business expenses (5,000) (3) Net self-employment (Schedule C) income $55,000 (1) + (2) (4) Percentage of self-employment income subject to self-employment tax 92.35% (5) Earnings from self-employment $50,793 (3) × (4) (6) Self-employment tax rate 15.3% Eva’s income is below the Social Security tax compensation limit for 2020 of $137,700, so entire earnings are subject to 15.3% rate. (7) Self-employment tax liability $7,771 (5) × (6); She is not subject to the additional Medicare tax because her net earnings from self-employment do not exceed $200,000. d. Assume that Eva is considered to be a self-employed contractor. What is her regular tax liability for the year? $3,519, as calculated below. Description Amount Explanation (1) Gross self-employment compensation $60,000 (2) Business expenses (5,000) (3) Net self-employment (Schedule C) income $55,000 (1) + (2) (4) For AGI deduction for employer portion of self-employment taxes (3,886) $50,793 × 7.65 = $3,886 ($55,000 x 92.35% = $50,793) (5) AGI $51,114 (3) + (4) (6) Standard deduction (12,400) (7) 20 percent deduction for qualified business income (7,743) Lesser of: (a) 20% of qualified business income [(20% x (3-4) = $51,114 x 20% = $10,223)] or (b) 20% of taxable income before qualified business income deduction [20% x ($51,114 - $12,400) = 7,743, rounded]. Eva is not subject to wage limit. Taxable income $30,971 (5) + (6) + (7) Regular tax liability $3,519 (30,971 – 9,875) × 12% + 987.50 [see tax rate schedule for Single individuals], rounded 69. [LO 3] {Research} Terry Hutchison worked as a self-employed lawyer until two years ago, when he retired. He used the cash method of accounting in his business for tax purposes. Five years ago, Terry represented his client ABC corporation in an antitrust lawsuit against XYZ corporation. During that year, Terry paid self-employment taxes on all of his income. ABC won the lawsuit, but Terry and ABC could not agree on the amount of his earnings. Finally, this year, the issue got resolved and ABC paid Terry $90,000 for the services he provided five years ago. Terry plans to include the payment in his gross income, but because he spends most of his time playing golf and absolutely no time working on legal matters, he does not intend to pay self-employment taxes on the income. Is Terry subject to self-employment taxes on this income? Yes, Terry is subject to self-employment tax on the income because as a cash method taxpayer he is subject to income tax and self-employment tax in the year that he receives the income. Because the income was derived from self-employment activities it is subject to self-employment taxes when Terry received it not when he earned it even though he was subject to self-employment taxes in the year when he earned the income. See Reg. §1.1402(a)-1(c) and F.L. Walker, CA-10, 2000-1 USTC ¶50,201, 202 F3d 1290. Note however, that the Walker case cited here is a 10th Circuit Court of Appeals decision in favor of the IRS. Originally in an unreported District Court decision the District Court ruled that Walker did not owe self-employment taxes on the income. However, the 10th Circuit Court of Appeals reversed the District Court decision. 70. [LO 4] Trey has two dependents, his two daughters, ages 14 and 17, at year-end. Trey files a joint return with his wife. What amount of child credit will Trey be able to claim for his daughters in each of the following alternative situations? a. His AGI is $100,000. $2,500. Because Trey’s AGI is less than the phase-out threshold ($400,000) for a joint return, Trey has a $2,000 child tax credit for his qualifying child age 14 (under 17) at year end and a $500 child tax credit for his qualifying dependent (not under 17 at year end). b. His AGI is $420,000. $1,500. Before phase-out, Trey has a $2,000 child tax credit for his qualifying child age 14 (under 17) at year end and a $500 child tax credit for his qualifying dependent (not under 17 at year end). The child tax credit of $1,500 is calculated using the steps below. (1) $420,000 AGI – $400,000 MFJ threshold = $20,000. (2) $20,000 excess AGI divided by 1,000 = 20 (3) 20 × 50 = $1,000. This is the amount of the phase-out. (4) $2,500 allowable credit minus $1,000 = $1,500 c. His AGI is $420,100 and his daughters are ages 10 and 12. $2,950. Before phase-out, Trey has a $2,000 child tax credit for each of his qualifying children ages 10 and 12 (under 17) at year end ($4,000 total). The child tax credit of $2,950 is calculated using the steps below. (1) $420,100 AGI – $400,000 MFJ threshold = $20,100. (2) $20,100 excess AGI divided by 1,000 = 21 (3) 21 × 50 = $1,050. This is the amount of the phase-out. (4) $4,000 allowable credit minus $1,050 = $2,950 71. [LO 4] Julie paid a day care center to watch her two-year-old son this year while she worked as a computer programmer for a local start-up company. What amount of child and dependent care credit can Julie claim in each of the following alternative scenarios? a. Julie paid $2,000 to the day care center and her AGI is $50,000 (all salary). Julie may claim $400 of the child and dependent care credit. Description Amount Explanation (1) Dependent care expenditures $2,000 (2) Limit on qualifying expenditures for one dependent $3,000 (3) Julie’s earned income $50,000 (4) Expenditures eligible for credit $2,000 Least of (1), (2), and (3) (5) Credit percentage rate 20% AGI over $43,000 Child and dependent care credit $400 (4) × (5) b. Julie paid $5,000 to the day care center and her AGI is $50,000 (all salary). Julie may claim $600 of the child and dependent care credit. Description Amount Explanation (1) Dependent care expenditures $5,000 (2) Limit on qualifying expenditures for one dependent $3,000 (3) Julie’s earned income $50,000 (4) Expenditures eligible for credit $3,000 Least of (1), (2), and (3) (5) Credit percentage rate 20% AGI over $43,000 Child and dependent care credit $600 (4) × (5) c. Julie paid $4,000 to the day care center and her AGI is $25,000 (all salary). Julie may claim $900 of the child and dependent care credit. Description Amount Explanation (1) Dependent care expenditures $4,000 (2) Limit on qualifying expenditures for one dependent $3,000 (3) Julie’s earned income $25,000 (4) Expenditures eligible for credit $3,000 Least of (1), (2), and (3) (5) Credit percentage rate 30% AGI over $23,000 but not over $25,000 Child and dependent care credit $900 (4) × (5) d. Julie paid $2,000 to the day care center and her AGI is $14,000 (all salary). Julie may claim $700 of the child and dependent care credit. Description Amount Explanation (1) Dependent care expenditures $2,000 (2) Limit on qualifying expenditures for one dependent $3,000 (3) Julie’s earned income $14,000 (4) Expenditures eligible for credit $2,000 Least of (1), (2), and (3) (5) Credit percentage rate 35% AGI over $0 but not over $15,000 Child and dependent care credit $700 (4) × (5) e. Julie paid $4,000 to the day care center and her AGI is $14,000 ($2,000 salary and $12,000 unearned income). Julie may claim $700 of the child and dependent care credit. Description Amount Explanation (1) Dependent care expenditures $4,000 (2) Limit on qualifying expenditures for one dependent $3,000 (3) Julie’s earned income $2,000 (4) Expenditures eligible for credit $2,000 Least of (1), (2), and (3) (5) Credit percentage rate 35% AGI over $0 but not over $15,000 Child and dependent care credit $700 (4) × (5) 72. [LO 4] In 2020, Elaine paid $2,800 of tuition and $600 for books for her dependent son to attend State University this past fall as a freshman. Elaine files a joint return with her husband. What is the maximum American opportunity tax credit Elaine can claim for the tuition payment and books in each of the following alternative situations? a. Elaine’s AGI is $80,000. Elaine may claim an American opportunity tax credit (AOTC) of $2,350. Description Amount Explanation (1) AOTC before phase-out $2,350 2,000 × 100% + (3,400 – 2,000) × 25% (2) AGI $80,000 (3) Phase-out threshold 160,000 (4) Excess AGI $0 (2) – (3) {but not <0 and limited to a maximum of $20,000} (5) Phase-out range for taxpayer filing as married filing jointly $20,000 $180,000 – $160,000 (6) Phase-out percentage 0% (4) / (5) or 100% max (7) Phase-out amount $0 (1) × (6) AOTC after-phase-out $2,350 (1) – (7) b. Elaine’s AGI is $168,000. Elaine may claim an AOTC of $1,410. Description Amount Explanation (1) AOTC before phase-out $2,350 2,000 × 100% + (3,400 – 2,000) × 25% (2) AGI $168,000 (3) Phase-out threshold 160,000 (4) Excess AGI $8,000 (2) – (3) (5) Phase-out range for taxpayer filing as married filing jointly $20,000 $180,000 – $160,000 (6) Phase-out percentage 40% (4) / (5) or 100% max (7) Phase-out amount $940 (1) × (6) AOTC after-phase-out $1,410 (1) – (7) c. Elaine’s AGI is $184,000. Because Elaine’s AGI exceeds the threshold amount, she may not claim an AOTC. Description Amount Explanation (1) AOTC before phase-out $2,350 2,000 × 100% + (3,400 – 2,000) × 25% (2) AGI $184,000 (3) Phase-out threshold 160,000 (4) Excess AGI $20,000 (2) – (3) (limited to $20,000) (5) Phase-out range for taxpayer filing as married filing jointly $20,000 $180,000 – $160,000 (6) Phase-out percentage 100% (4) / (5) (7) Phase-out amount $2,350 (1) × (6) AOTC after-phase-out $0 (1) – (7) 73. [LO 4] {Planning} In 2020, Laureen is currently single. She paid $2,800 of qualified tuition and related expenses for each of her twin daughters Sheri and Meri to attend State University as freshmen ($2,800 each for a total of $5,600). Sheri and Meri qualify as Laureen’s dependents. Laureen also paid $1,900 for her son Ryan’s (also Laureen’s dependent) tuition and related expenses to attend his junior year at State University. Finally, Laureen paid $1,200 for herself to attend seminars at a community college to help her improve her job skills. What is the maximum amount of education credits Laureen can claim for these expenditures in each of the following alternative scenarios? a. Laureen’s AGI is $45,000. If Laureen claims education credits for her three children and herself, how much credit is she allowed to claim in total? If she claims education credits for her children, how much of her children’s tuition costs that do not generate credits may she deduct as for AGI expenses? Because Laureen claimed education credits for her three children, she is not allowed to claim any for AGI deduction for the tuition costs of any of her children. Her education credits are $6,540, computed as follows: Laureen’s Education Credits Description Amount Explanation (1) American opportunity tax credit (AOTC) before phase-out for Sheri and Meri $4,400 [($2,000 × 100%) + ($800 × 25%)] x 2 students (2) AOTC before phase-out for Ryan 1,900 ($1,900 × 100%) (3) Total AOTC credit before phase-out 6,300 (1) + (2) (4) AGI $45,000 (5) Phase-out threshold 80,000 (6) Excess AGI 0 (4) – (5) {but not <0 and limited to a maximum of $10,000} (7) Phase-out range for single taxpayer $10,000 $90,000 – 80,000 (8) Phase-out percentage 0% (6) / (7) (9) Phase-out amount 0 (3) × (8) (10) Total AOTC after phase-out 6,300 (3) – (9) (11) Lifetime learning credit before phase-out for Laureen $240 $1,200 × 20% (12) AGI $45,000 (13) Phase-out threshold 59,000 (14) Excess AGI 0 (12) – (13) {but not <0 and limited to a maximum of $10,000} (15) Phase-out range for taxpayer filing as Single $10,000 $69,000 – 59,000. (16) Phase-out percentage 0% (14) / (15) (17) Phase-out amount 0 (16) × (11) (18) Lifetime learning credit after phase-out $240 (11) – (17) Total education credits $6,540 (10) + (18) b. Laureen’s AGI is $95,000. What options does Laureen have for deducting her continuing education costs to the extent the costs don’t generate a credit? $0 education credit and $0 qualified tuition deduction. See below: Laureen’s Education Credits Description Amount Explanation (1) AOTC before phase-out for Sheri and Meri $4,400 [($2,000 × 100%) + ($800 × 25%)] × 2 students (2) AOTC before phase-out for Ryan 1,900 ($1,900 × 100%) (3) Total AOTC credit before phase-out 6,300 (1) + (2) (4) AGI $95,000 (5) Phase-out threshold 80,000 (6) Excess AGI 10,000 (4) – (5) {but not <0 and limited to a maximum of $10,000} (7) Phase-out range for single taxpayer $10,000 $90,000 – 80,000 (8) Phase-out percentage 100% (6) / (7) (not 100%) (9) Phase-out amount 6,300 (3) × (8) (10) Total AOTC after phase-out 0 (3) – (9) (11) Lifetime learning credit before phase-out for Laureen $240 $1,200 × 20% (12) AGI $95,000 (13) Phase-out threshold 59,000 (14) Excess AGI 10,000 (12) – (13) {but not <0 and limited to a maximum of $10,000} (15) Phase-out range for taxpayer filing as Single $10,000 $69,000 – 59,000. (16) Phase-out percentage 100% (14) / (15) (not 100%) (17) Phase-out amount 240 (16) × (11) (18) Lifetime learning credit after phase-out $0 (11) – (17) Total education credits $0 (10) + (18) Because Laureen was not able claim any education credits she is allowed to claim a for AGI deduction for up to $4,000 of the tuition and fees she paid for her children. However, because her AGI is greater than $80,000, she is not allowed to claim any for AGI deduction for tuition and fees. c. Laureen’s AGI is $45,000 and Laureen paid $12,000 (not $1,900) for Ryan to attend graduate school (i.e., his fifth year, not his junior year). $6,400 education credits ($4,400 AOTC for Sheri and Meri + $2,000 lifetime learning credit for Ryan and herself). See computations below. Laureen’s Education Credits Description Amount Explanation (1) AOTC before phase-out for Sheri and Meri $4,400 [($2,000 × 100%) + ($800 × 25%)] × 2 students (2) AGI $45,000 (3) Phase-out threshold 80,000 (4) Excess AGI 0 (2) – (3) {but not <0 and limited to a maximum of $10,000} (5) Phase-out range for single taxpayer $10,000 $90,000 – 80,000 (6) Phase-out percentage 0% (4) / (5) (7) Phase-out amount 0 (3) × (6) (8) Total AOTC after phase-out 4,400 (1) – (7) (9) Lifetime learning credit before phase-out $2,000 $240 ($1,200 × 20%) for herself and $2,000 ($10,000 × 20%) for Ryan. However, total limited to $2,000 ($10,000 × 20%) per tax return. (10) AGI $45,000 (11) Phase-out threshold 59,000 (12) Excess AGI 0 (10) – (11) {but not <0 and limited to a maximum of $10,000} (13) Phase-out range for taxpayer filing as Single $10,000 $69,000 – 59,000. (14) Phase-out percentage 0% (12) / (13) (15) Phase-out amount 0 (14) × (9) (16) Lifetime learning credit after phase-out $2,000 (9) – (15) Total education credits $6,400 (8) + (16) 74. [LO 4] In 2020, Amanda and Jaxon Stuart have a daughter who is one year old. The Stuarts are full-time students and they are both 23 years old. Their only sources of income are gains from stock they held for three years before selling and wages from part-time jobs. What is their earned income credit in the following alternative scenarios if they file jointly? a. Their AGI is $15,000, consisting of $5,000 of capital gains and $10,000 of wages. $0 earned income credit. Based on §32(i), taxpayers with investment income in excess of $3,650 are not eligible for the earned income credit. Because capital gains are considered as investment income for this purpose, the Stuarts are not eligible for the credit. b. Their AGI is $15,000, consisting of $10,000 of lottery winnings (unearned income) and $5,000 of wages. $1,700, computed as follows: Description Amount Explanation (1) Earned income $5,000 (2) Maximum earned income eligible for earned income credit for taxpayers filing as married filing jointly with one qualifying child 10,540 (3) Earned income eligible for credit $5,000 Lesser of (1) or (2). (4) Earned income credit percentage 34% Married filing jointly taxpayer with one qualifying child (5) Earned income credit before phase-out $1,700 (3) × (4). (6) Phase-out threshold begins at this level of AGI (or earned income if greater) $25,220 See Exhibit 8-10 for MFJ filing status and one qualifying child (7) AGI (or earned income if greater) in excess of phase-out threshold $0 (1) – (6), limited to $0. (8) Phase-out percentage 15.98% (9) Credit phase-out amount 0 (7) × (8). Earned income credit after phase-out $1,700 (5) – (9). c. Their AGI is $28,000, consisting of $23,000 of wages and $5,000 of lottery winnings (unearned income). $3,140, computed as follows: Description Amount Explanation (1) Earned Income $23,000 (2) Maximum earned income eligible for earned income credit for taxpayers filing as MFJ with one qualifying child 10,540 (3) Earned income eligible for credit 10,540 Lesser of (1) or (2) (4) Earned income credit percentage 34% Married filing jointly taxpayer with one qualifying child (5) Earned income credit before phase-out $3,584 (3) × (4) (6) Phase-out threshold begins at this level of AGI (or earned income if greater) $25,220 See Exhibit 8-10 for MFJ filing status and one qualifying child (7) AGI (or earned income if greater) in excess of phase—out threshold $2,780 $28,000 AGI – (6) (8) Phase-out percentage 15.98% See Exhibit 8-10 (9) Credit phase-out amount 444 (7) × (8), rounded Earned income credit after phase-out $3,140 (5) - (9) d. Their AGI is $28,000, consisting of $5,000 of wages and $23,000 of lottery winnings (unearned income). $1,256, computed as follows: Description Amount Explanation (1) Earned Income $5,000 (2) Maximum earned income eligible for earned income credit for taxpayers filing as MFJ with one qualifying child 10,540 (3) Earned income eligible for credit 5,000 Lesser of (1) or (2) (4) Earned income credit percentage 34% Married filing jointly taxpayer with one qualifying child (5) Earned income credit before phase-out $1,700 (3) × (4) (6) Phase-out threshold begins at this level of AGI (or earned income if greater) $25,220 See Exhibit 8-10 for MFJ filing status and one qualifying child (7) AGI (or earned income if greater) in excess of phase—out threshold $2,780 $28,000 AGI – (6) (8) Phase-out percentage 15.98% See Exhibit 8-10 (9) Credit phase-out amount 444 (7) × (8), rounded Earned income credit after phase-out $1,256 (5) - (9) e. Their AGI is $10,000, consisting of $10,000 of lottery winnings (unearned income). They are not eligible for the earned income credit because they have no earned income. 75. [LO 4] In 2020, Zach is single with no dependents. He is not claimed as a dependent on another’s return. All of his income is from salary and he does not have any for AGI deductions. What is his earned income credit in the following alternative scenarios? a. Zach is 29 years old and his AGI is $5,000. Zach may claim an earned income credit of $383, computed as follows: Description Amount Explanation (1) Earned Income $5,000 (2) Maximum earned income eligible for earned income credit for taxpayers filing as singe with no qualifying children 7,030 (3) Earned income eligible for credit 5,000 Lesser of (1) or (2) (4) Earned income credit percentage 7.65% Single taxpayer with no qualifying children (5) Earned income credit before phase-out $383 (3) × (4) (6) Phase-out threshold begins at this level of AGI (or earned income if greater) $8,790 See Exhibit 8-10 for single filing status and no qualifying children (7) AGI (or earned income if greater) in excess of phase—out threshold $0 $5,000 AGI – (6), limited to $0 (8) Phase-out percentage 7.65% See Exhibit 8-10 (9) Credit phase-out amount 0 (7) × (8) Earned income credit after phase-out $383 (5) - (9) b. Zach is 29 years old and his AGI is $10,000. Zach may claim $445 of earned income credit, computed as follows: Description Amount Explanation (1) Earned Income $10,000 (2) Maximum earned income eligible for earned income credit for taxpayers filing as singe with no qualifying children 7,030 (3) Earned income eligible for credit 7,030 Lesser of (1) or (2) (4) Earned income credit percentage 7.65% Single taxpayer with no qualifying children (5) Earned income credit before phase-out $538 (3) × (4) (6) Phase-out threshold begins at this level of AGI (or earned income if greater) $8,790 See Exhibit 8-10 for single filing status and no qualifying children (7) AGI (or earned income if greater) in excess of phase—out threshold $1,210 $10,000 AGI – (6), limited to $0 (8) Phase-out percentage 7.65% See Exhibit 8-10 (9) Credit phase-out amount 93 (7) × (8) rounded, limited to (5) Earned income credit after phase-out $445 (5) - (9) c. Zach is 29 years old and his AGI is $19,000. $0. Zach may not claim an earned income credit because his AGI is above the threshold where the entire credit is phased-out. Description Amount Explanation (1) Earned Income $19,000 (2) Maximum earned income eligible for earned income credit for taxpayers filing as singe with no qualifying children 7,030 (3) Earned income eligible for credit 7,030 Lesser of (1) or (2) (4) Earned income credit percentage 7.65% Single taxpayer with no qualifying children (5) Earned income credit before phase-out $538 (3) × (4) (6) Phase-out threshold begins at this level of AGI (or earned income if greater) $8,790 See Exhibit 8-10 for single filing status and no qualifying children (7) AGI (or earned income if greater) in excess of phase—out threshold $10,210 $19,000 AGI – (6), limited to $0 (8) Phase-out percentage 7.65% See Exhibit 8-10 (9) Credit phase-out amount 538 (7) × (8) = $781, limited to (5) Earned income credit after phase-out $0 (5) - (9), limited to $0 d. Zach is 24 years old and his AGI is $5,000. Zach is not eligible for the earned income credit because he is not a qualified individual. To be a qualified individual, Zach must be either (1) an individual with at least one qualifying child or (2) at least 25 years old, but not more than 65, and have lived in the U.S. for at least half of the year. Because he has no children and he is not 25 years old, he does not qualify for the credit. 76. [LO 4] This year Luke has calculated his gross tax liability at $1,800. Luke is entitled to a $2,400 nonrefundable personal tax credit, a $1,500 business tax credit, and a $600 refundable personal tax credit. In addition, Luke has had $2,300 of income taxes withheld from his salary. What is Luke’s net tax due or refund? Luke’s nonrefundable personal credit reduces his gross tax to zero ($1,800 – 2,400) and $600 of the unused credit expires unused. The $1,500 unused business tax credit carries over and Luke receives a refund of $2,900 ($600 refundable credit + $2,300 taxes he paid). 77. [LO 5] {Planning} This year Lloyd, a single taxpayer, estimates that his tax liability will be $10,000. Last year, his total tax liability was $15,000. He estimates that his tax withholding from his employer will be $7,800. a. Is Lloyd required to increase his withholding or make estimated tax payments this year to avoid the underpayment penalty? If so, how much? Taxpayers can avoid an underpayment penalty if their withholdings and estimated tax payments equal or exceed one of the following two safe harbors: (1) 90 percent of their current tax liability [$10,000 x 90% = $9,000 for Lloyd] or (2) 100 percent of their previous year tax liability (110 percent for individuals with AGI greater than $150,000). [100% of $15,000 for Lloyd assuming his AGI was $150,000 or less]. Since Lloyd’s withholding does not equal or exceed $9,000 (safe harbor 1) or $15,000 (safe harbor 2), he will need to increase his withholding or make estimated payments this year to avoid the underpayment penalty. If he increases his withholding by $1,200 ($9,000 - $7,800) or makes four quarterly estimated payments of $300 each, he will avoid the underpayment penalty (assuming his current year tax projection is accurate). b. Assuming Lloyd does not make any additional payments, what is the amount of his underpayment penalty? Assume the federal short-term rate is 5 percent. With an 8% penalty rate (federal short-term rate of 5% plus 3%), Lloyd will owe $60 in underpayment penalty computed as following: Dates (1) Actual withholding (2) Required withholding (1) – (2) Over (Under) withheld Penalty Per Quarter April 15th $1,950 ($7,800 x ¼) $2,250 ($10,000 x .9 x .25) $(300) $300 x 8% x ¼ = $6 June 15th 3,900 ($7,800 x ½) 4,500 ($10,000 x .9 x .50) (600) $600 x 8% x ¼ = $12 September 15th 5,850 ($7,800 x ¾) 6,750 ($10,000 x .9 x .75) (900) $900 x 8% x ¼ = $18 January 15th 7,800 9,000 ($10,000 x .9 x 1) (1,200) $1,200 x 8% x ¼ = $24 Total = $60 78. [LO 5] {Planning} This year, Paula and Simon (married filing jointly) estimate that their tax liability will be $200,000. Last year, their total tax liability was $170,000. They estimate that their tax withholding from their employers will be $175,000. Are Paula and Simon required to increase their withholdings or make estimated tax payments this year to avoid the underpayment penalty? If so, how much? Taxpayers can avoid an underpayment penalty if their withholdings and estimated tax payments equal or exceed one of the following two safe harbors: (1) 90 percent of their current tax liability [$200,000 x 90% = $180,000 for Paula and Simon] or (2) 100 percent of their previous year tax liability (110 percent for individuals with AGI greater than $150,000). [110% of $170,000 = $187,000 for Paula and Simon because their AGI was more than $150,000]. Since Paula and Simon’s withholdings do not equal or exceed $180,000 (safe harbor 1) or $187,000 (safe harbor 2), they will need to increase their withholdings or make estimated payments this year to avoid the underpayment penalty. If they increase their withholdings by $5,000 ($180,000 - $175,000) or make four quarterly estimated payments of $1,250 each, they will avoid the underpayment penalty (assuming their current tax projection is accurate). 79. [LO 5] {Planning} This year, Santhosh, a single taxpayer, estimates that his tax liability will be $100,000. Last year, his total tax liability was $15,000. He estimates that his tax withholding from his employer will be $35,000. Is Santhosh required to increase his withholding or make estimated tax payments this year to avoid the underpayment penalty? If so, how much? Taxpayers can avoid an underpayment penalty if their withholdings and estimated tax payments equal or exceed one of the following two safe harbors: (1) 90 percent of their current tax liability [$100,000 x 90% = $90,000 for Santhosh] or (2) 100 percent of their previous year tax liability (110 percent for individuals with AGI greater than $150,000). [100% of $15,000 for Santhosh assuming his AGI was $150,000 or less last year]. Since Santhosh’s withholding of $35,000 exceeds $15,000 (safe harbor 2), he will not need to increase his withholding or make estimated payments this year to avoid the underpayment penalty. In this situation, Santhosh should be careful to plan for his impending large tax payment ($100,000 - $35,000 withholding) due by the original due date of his tax return. In the meantime, he should enjoy the $65,000 “interest-free” loan the government is giving him. 80. [LO 5] For the following taxpayers, determine if they are required to file a tax return in 2020. a. Ricko, single taxpayer, with gross income of $15,000. Ricko is required to file a tax return because his gross income of $15,000 exceeds the applicable gross income threshold of $12,400 ($12,400 standard deduction). b. Fantasia, head of household, with gross income of $17,500. Fantasia is not required to file a tax return because her gross income of $17,500 is less than the applicable gross income threshold of $18,650 ($18,650 standard deduction). c. Ken and Barbie, married taxpayers with no dependents, with gross income of $20,000. Ken and Barbie are not required to file a tax return because their gross income of $20,000 is less than the applicable gross income threshold of $24,800 [$24,800 standard deduction]. d. Dorothy and Rudolf, married taxpayers, both age 68, with gross income of $25,500. Dorothy and Rudolf are not required to file a tax return because their gross income of $25,500 is less than the applicable gross income threshold of $27,400 [$24,800 standard deduction + (2 × 1,300)] additional standard deduction for age). e. Janyce, single taxpayer, age 73, with gross income of $13,500. Janyce is not required to file a tax return because her gross income of $13,500 is less than the applicable gross income threshold of $14,050 ($12,400 + 1,650 additional standard deduction for age). 81. [LO 5] For the following taxpayers, determine the due date of their tax returns. a. Jerome, single taxpayer, is not requesting an extension this year. Assume the due date falls on a Tuesday. Since Jerome does not request an extension to file this year and the original due date falls during the week (i.e., not a Saturday, Sunday, or holiday), Jerome’s tax return will be due April 15th. b. Lashaunda, a single taxpayer, requests an extension this year. Assume the extended due date falls on a Wednesday. Since Lashaunda requests a 6-month extension to file and the extended due date falls during the week (i.e., not a Saturday, Sunday, or holiday), Lashaunda’s tax return will be due October 15th (i.e., 6 months from the original due date of April 15th). c. Barney and Betty, married taxpayers, do not request an extension this year. Assume the due date falls on a Sunday. Since Barney and Betty do not request an extension this year and the original due date (April 15th) falls on a Sunday, the due date will be April 16th (the next day that is not a Saturday, Sunday, or holiday). d. Fred and Wilma, married taxpayers, request an extension this year. Assume the extended date falls on a Saturday. Since Fred and Wilma requested an extension this year and the extended due date (October 15) falls on a Saturday, the due date will be October 17th (the next day that is not a Saturday, Sunday, or holiday). 82. [LO 5] {Planning} Determine the amount of the late filing and late payment penalties that apply for the following taxpayers. a. Jolene filed her tax return by its original due date but did not pay the $2,000 in taxes she owed with the return until one and a half months later. $20. Jolene will owe 2 months of the late payment penalty at .5% per month (i.e., 1% of her $2000 underpayment). b. Oscar filed his tax return and paid his $3,000 tax liability seven months late. $750. Oscar will owe the maximum late filing and late payment penalties of 25% of his underpayment ($3,000 × 25%). These penalties are capped at 5% per month and 25% in total. c. Wilfred, attempting to evade his taxes, did not file a tax return or pay his $10,000 in taxes for several years. $7,500. Wilfred will owe the maximum late filing and late payment penalties of 75% of his underpayment that applies when fraud is committed ($10,000 x 75%). These penalties are capped at 15% per month and 75% in total. Comprehensive Problems 83. In 2020, Jack is single two children, ages 10 and 12. Jack works full time and earns an annual salary of $195,000 as a consultant. Jack files as a head of household and does not itemize his deductions. In the fall of this year, he was recently offered a position with another firm that would pay him an additional $35,000. a. Calculate the marginal tax rate on the additional income, excluding employment taxes, to help Jack evaluate the offer. If Jack refuses the position, his 2020 AGI is $195,000, his taxable income is $176,350 [$195,000 - 18,650] and his gross tax is $36,006. His marginal tax rate is 32%. He qualifies for the full $4,000 of child tax credit (2 × $2,000) because his AGI is below the phase-out threshold of $200,000, therefore, his net tax is $32,006. If Jack accepts the position, his AGI and taxable income will increase by $35,000 and he will now be in the 35% tax bracket. Since his AGI is now $230,000, it triggers the phase-out of the child tax credit. His increased AGI exceeds the phase-out threshold by $30,000 which reduces their child tax credit by $1,500 [$50 × 30 (30,000 / 1,000)]. Hence, Jack’s net tax on the income increases by $12,820 and his effective marginal tax rate on the income is 36.6% ($12,820/$35,000). Description Decline Offer Accept Offer Reference (1) AGI $195,000 $230,000 195,000 + 35,000 (if accepted) (2) Standard deduction 18,650 18,650 HOH standard deduction (3) Taxable income $176,350 $211,350 (1) – (2) (4) Tax liability $36,006 $47,326 See tax tables for HOH, rounded (5) Child tax credit (4,000) (2,500) See analysis above (6) Tax due/(refund) $32,006 $44,826 (4) + (5) (7) Net tax increase if offer is accepted $12,820 $44,826 - $32,006 Marginal tax on additional income if offer is accepted 36.6% 12,820 / 35,000, rounded b. Calculate the marginal tax rate on the additional income, including employment taxes, to help Jack evaluate the offer. If Jack refuses the position, his 2020 AGI is $195,000, his taxable income is $176,350 [$195,000 - 18,650] and his gross tax is $36,006. His marginal tax rate is 32%. Because he qualifies for $4,000 of child tax credit (2 × $2,000), his net tax is $32,006. Jack’s FICA taxes are $11,365 [($137,700 x 6.2%) + ($195,000 x 1.45%)]. So, Jack’s total tax liability without the additional income is $43,371 ($32,006+ $11,365)). If Jack accepts the position, his AGI and taxable income will increase by $35,000 he will now be in the 35% tax bracket. His gross tax will increase by $11,320 ($47,326 - $36,006). However, since his AGI is now $230,000, it triggers the phase-out of the child tax credit. His increased AGI exceeds the phase-out threshold by $30,000 which reduces their child tax credit by $1,500 [$50 × 30 (30,000 / 1,000)]. Also, his FICA taxes increase by $778 [($5,000 ×1.45%) + ($30,000 x 2.35)]. Hence, Jack’s net tax on the income increases by $13,598 ($11,320 + $1,500 + $778) and his effective marginal tax rate on the income is 38.9% ($13,598/$35,000). Description Decline Offer Accept Offer Reference (1) AGI $195,000 $230,000 195,000 + 35,000 (if accepted) (2) Standard deduction 18,650 18,650 HOH standard deduction (3) Taxable income $176,350 $211,350 (1) – (2) (4) Tax liability $36,006 $47,326 See tax tables for HOH (5) Child tax credit (4,000) (2,500) See analysis above (6) Employment taxes 11,365 12,143 See analysis above (7) Tax due/(refund) $43,371 $56,969 (4) + (5) + (6) (8) Net tax increase if offer is accepted 13,598 56,969 – 43,371 Marginal tax if offer is accepted 38.9% 13,598/35,000, rounded 84. {Tax Forms} Reba Dixon is a fifth-grade school teacher who earned a salary of $38,000 in 2020. She is 45 years old and has been divorced for four years. She received $1,200 of alimony payments each month from her former husband (divorced in 2016). Reba also rents out a small apartment building. This year Reba received $50,000 of rental payments from tenants and she incurred $19,500 of expenses associated with the rental. Reba and her daughter Heather (20 years old at the end of the year) moved to Georgia in January of this year. Reba provides more than one-half of Heather’s support. They had been living in Colorado for the past 15 years, but ever since her divorce, Reba has been wanting to move back to Georgia to be closer to her family. Luckily, last December, a teaching position opened up and Reba and Heather decided to make the move. Reba paid a moving company $2,010 to move their personal belongings, and she and Heather spent two days driving the 1,426 miles to Georgia. Reba rented a home in Georgia. Heather decided to continue living at home with her mom, but she started attending school full time in January and throughout the rest of the year at a nearby university. She was awarded a $3,000 partial tuition scholarship this year, and Reba helped out by paying the remaining $500 tuition cost. If possible, Reba thought it would be best to claim the education credit for these expenses. Reba wasn't sure if she would have enough items to help her benefit from itemizing on her tax return. However, she kept track of several expenses this year that she thought might qualify if she was able to itemize. Reba paid $5,800 in state taxes and $12,500 in charitable contributions during the year. She also paid the following medical-related expenses for herself and Heather: Insurance premiums $7,952 Medical care expenses $1,100 Prescription medicine $350 Nonprescription medicine $100 New contact lenses for Heather $200 Shortly after the move, Reba got distracted while driving and she ran into a street sign. The accident caused $900 in damage to the car and gave her whiplash. Because the repairs were less than her insurance deductible, she paid the entire cost of the repairs. Reba wasn’t able to work for two months after the accident. Fortunately, she received $2,000 from her disability insurance. Her employer, the Central Georgia School District, paid 60 percent of the premiums on the policy as a nontaxable fringe benefit and Reba paid the remaining 40 percent portion. A few years ago, Reba acquired several investments with her portion of the divorce settlement. This year she reported the following income from her investments: $2,200 of interest income from corporate bonds and $1,500 interest income from the City of Denver municipal bonds. Overall, Reba’s stock portfolio appreciated by $12,000, but she did not sell any of her stocks. Heather reported $6,200 of interest income from corporate bonds she received as gifts from her father over the last several years. This was Heather’s only source of income for the year. Reba had $10,000 of federal income taxes withheld by her employer. Heather made $1,000 of estimated tax payments during the year. Reba did not make any estimated payments. Required: a. Determine Reba’s federal income taxes due or taxes payable for the current year. Complete pages 1 and 2, Schedule 1, and Schedule 3 of Form 1040 for Reba. Description Amount Explanation Gross Income: Salary $38,000 Alimony received 14,400 $1,200 per month × 12 months Rental receipts 50,000 Gift from mother 0 $3,000 gift excluded from income Disability insurance payments 1,200 $800 of $2,000 (40%) of payment excluded because taxpayer paid 40% of premium on insurance policy Interest income from corporate bonds 2,200 Interest income from municipal bonds 0 (1) Gross income $105,800 Deductions for AGI: Expenses for rental property 19,500 (2) Total for AGI deductions 19,500 (3) AGI $86,300 (1) – (2) From AGI deductions: Medical expenses $3,129 $9,602 – 6,473 [7.5% × (3)] = $3,129 State income taxes 5,800 Charitable contributions 12,500 (4) Total itemized deductions 21,429 (5) Standard deduction 18,650 Head of household filing status. See Note A. below (6) Greater of itemized deductions or standard deduction 21,429 Greater of (4) or (5) (7) Taxable income $64,871 (3) – (6) (8) Tax on taxable income $8,620 See head of household tax rate schedule; $6,162 + 2,458 [22% × (64,871 – 53,700)], rounded (9) Credits 685 American opportunity tax credit of $185 for $500 tuition paid on Heather’s behalf and $500 child tax credit (see Note D) (10) Tax prepayments 10,000 Withholding Tax refund with return $(2,065) (8) – (9) - (10). Note A. The moving expenses and repair costs from her accident are nondeductible. Note B. Medical expenses: All of the medical expenses qualify for the deduction except the nonprescription medicine. Note C. The first question we have to answer to determine Reba’s filing status is whether she can claim Heather as a dependent. If so, she may qualify for head of household filing status. If not, she will file a single taxpayer. Does Heather qualify as Reba’s dependent? Yes, as analyzed below. Test Is Heather a qualifying child of Reba? Relationship Yes, daughter Age Yes, under age 24 and a full- time student (and younger than Reba). Residence Yes, Heather had the same principal residence as Reba for the entire year. Support Yes. Heather did not provide more than half of her own support. Her scholarship does not count as support she provided for herself because she is Reba’s child. Note D: Reba may claim a $500 child tax credit for Heather because Heather is a qualifying dependent (but not a qualified child under age 17). Because Reba’s AGI ($86,300) is in the phase-out range for the American opportunity tax credit (i.e., between $80,000 - $90,000), she may not take the full $500 AOTC credit. Instead, she is limited to a $185 credit (($500 qualified expenses x [1 – (($86,300 AGI - $80,000 Phase-out threshold)/$10,000 phase-out range)]) = ($500 x [1 - .63]) = $185). Note that 40% of the AOTC is refundable ($185 x .40 = $74) and appears on line 18c of page 2, Form 1040; the remaining $111 ($185 - $74 = $111) is nonrefundable and appears on line 13b of page 2, Form 1040. b. Is Reba allowed to file as a head of household or single? Head of Household. To qualify as head of household, a taxpayer must pay more than half the costs of maintaining a household that is the principal place of abode for a dependent who is a qualifying child (or for maintaining a separate household for her mother or father if the mother or father also qualifies as a dependent of the taxpayer). Reba pays all the costs of providing the home in which she and Heather reside. Consequently, she may file as a head of household. c. Determine the amount of FICA taxes Reba was required to pay on her salary. Reba’s entire $38,000 is subject to FICA taxes. Because her salary amount is under the social security wage base, Reba pays 7.65% of her salary as FICA taxes. Consequently, her employer should have withheld $2,907 of FICA taxes during the year ($38,000 × 7.65%). d. Determine Heather’s federal income taxes due or payable. $10 refund. Description Amount Explanation Gross income and AGI: (1) Scholarship $0 Used for tuition so all excluded from income. (2) Interest income 6,200 (3) Gross income and AGI: $6,200 (1) + (2) no deductions for AGI (4) Standard deduction 1,100 Greater of (1) $1,100 and (2) 350 + 0 earned income (5) Taxable income $5,100 (3) – (4) (6) Income taxed at Heather’s rate 1,100 Kiddie tax applies because Heather is under 24 years old and does not provide more than half her own support. (7) Marginal tax rate on first $1,100 of child’s income 10% See single income tax rate schedule. (8) Tax on unearned income at Heather’s rate 110 (6) x (7) (9) Net unearned income $4,000 Lesser {(3) – 2,200} or (5) (10) Tax on net unearned income 880 (9) x 22%, Reba’s Marginal Tax Rate (11) Heather’s tax liability $990 (8) + (10) (12) Tax prepayments 1,000 Tax (refund) ($10) (11) – (12) 85. {Tax Forms} John and Sandy Ferguson got married eight years ago and have a seven-year-old daughter, Samantha. In 2020, John worked as a computer technician at a local university earning a salary of $152,000, and Sandy worked part time as a receptionist for a law firm earning a salary of $29,000. John also does some Web design work on the side and reported revenues of $4,000 and associated expenses of $750. The Fergusons received $800 in qualified dividends and a $200 refund of their state income taxes. The Fergusons always itemize their deductions, and their itemized deductions were well over the standard deduction amount last year. The Fergusons reported making the following payments during the year: • State income taxes of $4,400. Federal tax withholding of $21,000. • Alimony payments to John’s former wife $10,000 (divorced in 2014). • Child support payments for John’s child with his former wife $4,100. • $12,200 of real property taxes. • Sandy was reimbursed $600 for employee business expenses she incurred. • $3,600 to Kid Care daycare center for Samantha’s care while John and Sandy worked. • $14,000 interest on their home mortgage ($400,000 acquisition debt) • $3,000 interest on a $40,000 home-equity loan. They used the loan to pay for family vacation and new car. • $15,000 cash charitable contributions to qualified charities. • Donation of used furniture to Goodwill. The furniture had a fair market value of $400 and cost $2,000. Required: What is the Fergusons’ 2020 federal income taxes payable or refund, including any self-employment tax and AMT, if applicable? Complete Form 1040, pages 1 and 2, Schedule 1, Schedule 2, and Schedule 3 of Form 1040 and Form 6251 for John and Sandy. Answer: $2,253 refund, computed as follows: Description Amount Explanation Gross income: Note: Sandy’s reimbursement for her employee business expenses is excluded from gross income. Salary $181,000 ($152,000 + $29,000) Self-employment revenues 4,000 Dividends 800 State income tax refund 200 (1) Gross income 186,000 For AGI deductions: Self-employment expenses 750 Employer portion of self-employment taxes 44 $3,250 × 92.35% × 1.45% = $44. See Note A below. Alimony 10,000 Since the divorce occurred in 2014 alimony payment are still deductible. However, the child support payments of $4,100 are not deductible. (2) Total for AGI deductions 10,794 (3) AGI 175,206 (1) - (2) Itemized deductions: Taxes 10,000 State income taxes of $4,400 and real property taxes of $12,200, limited to $10,000 Home mortgage interest expense 14,000 (Home equity interest is not deductible) Charitable contributions cash 15,000 Charitable contributions property 400 Lesser of fair market value or basis (4) Total itemized deductions 39,400 Standard deduction for MFJ is $24,800 so the Fergusons deduct itemized deductions (5) Deduction for qualified business income 641 [20% x ($4,000 business income - $750 business expenses – $44 one-half of self-employment taxes deducted above-the-line)], not subject to wage limitation because taxable income is less than $326,600 (6) Total from AGI deductions 40,041 (4) + (5) Taxable income $135,165 (3) – (6) (7) Tax on income other than qualified dividends $21,140 $135,165 – 800 = $134,365. Tax = $21,140, rounded. from MFJ tax rate schedule $9,235 + 11,905.30 [22% × (134,365 – 80,250)] (8) Tax on qualified dividends 120 $800 × 15%; all $800 falls within 15% tax bracket for preferential income which spans taxable income of $80,001 - $496,600. (9) Total Federal income tax $21,260 (7) + (8) (10) Self Employment tax 87 See Note A below: (11) Alternative Minimum tax 0 See Note C below (12) Total taxes $21,347 (9) + (10) +(11) (13) Child and dependent care credit 600 See Note B below. (14) Child tax credit 2,000 One qualifying child (15) Federal tax withholding 21,000 Tax payable (refund) ($2,253) (12) – (13) – (14)- (15) Note A: John’s self-employment taxes are computed as follows: Description Amount Explanation (1) Self-employment revenue $4,000 Expenses: (2) Day to day expenses 750 Net self-employment income $3,250 (1) – (2) Tax on self-employment income (John is over the 2020 wage base limit of $137,700 for social security taxes, therefore, he only owes his share of Medicare taxes) is $3,250 × 92.35% × 2.9% = $87. One-half of this amount ($44) is deductible as a for AGI deduction. Note B: Child and dependent care credit: Description Amount Explanation (1) Child and dependent care expenditures $3,600 (2) Limit on qualifying expenditures for one dependent $3,000 (3) Fergusons’ earned income $184,250 $181,000 salary + $3,250 net self-employment income = $184,250 (4) Expenditures eligible for credit $3,000 Least of (1), (2), and (3) (5) Credit percentage rate 20% AGI over $43,000 Child and dependent care credit $600 (4) × (5) Note C: Alternative minimum tax Description Amount Explanation (1) Taxable income $135,165 Plus adjustments: (2) Taxes 10,000 Minus adjustments: (3) State income tax refund (200) (4) Alternative minimum taxable income $144,965 (1) + (2) + (3) (5) AMT Exemption $113,400 MFJ 2020 exemption amount; not subject to phaseout because AMTI (7) so, $0 Solution Manual for McGraw-Hill's Taxation of Individuals and Business Entities 2021 Brian C. Spilker, Benjamin C. Ayers, John A. Barrick, Troy Lewis, John Robinson, Connie Weaver, Ronald G. Worsham 9781260247138, 9781260432534
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