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12-4 2006 Comprehensive Volume/Solutions CHAPTER 12

DISCUSSION QUESTIONS

1. A taxpayer whose marginal tax rate is less than 25% would be better off taking a credit of
25%. However, if the marginal rate is greater than 25%, a taxpayer would benefit more
from taking a deduction. Alternatively, if the item were deductible from AGI (i.e., as an
itemized deduction), a benefit would result only if the taxpayer itemized his or her
deductions. p. 12-3 and Example 4

2. Refundable credits are payable to the taxpayer even if the amount of the credit (or
credits) exceeds the taxpayer’s tax liability. Examples of refundable credits include taxes
withheld on wages and the earned income credit.

Nonrefundable credits are not refunded if they exceed the taxpayer’s tax liability.
Examples of such credits are the general business credit and the tax credit for the elderly
or disabled. Some nonrefundable credits, such as the general business credit, are subject
to carryover rules if they exceed the amount allowable as a credit in a given year.

pp. 12-4, 12-5, and Exhibit 12-1

3. a. Net income tax is the sum of the regular tax liability and the alternative minimum
tax reduced by certain nonrefundable tax credits.

Tentative minimum tax for this purpose is the tentative minimum tax reduced by
the foreign tax credit allowed.

Regular tax liability is determined from the appropriate tax table or tax rate
schedule, based on taxable income. However, this term does not include certain
taxes, such as the alternative minimum tax.

Net regular tax liability is the regular tax liability reduced by certain
nonrefundable credits, such as the credit for child and dependent care expenses
and the foreign tax credit.

b. The general business credit is limited to the taxpayer’s net income tax reduced by
the greater of:

• The tentative minimum tax.

• 25% of net regular tax liability that exceeds $25,000.

p. 12-6

4. Unused general business credits are initially carried back one year and are applied to
reduce the income tax during that year. Any remaining unused credits are then carried
forward for up to 20 years. A FIFO method is applied to the carryback, carryovers, and
utilization of credits earned during a particular year. p. 12-6

5. Among the relevant tax issues are the following:

• Ability to use tax credits currently and the use of suspended credits. pp. 12-4 to 12-7

• The impact of the at-risk and passive activity loss rules on the deductibility of the
losses and the ability to benefit from the tax credits. Chapter 11
Tax Credits 12-5

• The at-risk amount (how the loan guarantee affects the calculation of the at-risk
amount). Chapter 11

• Interaction between the at-risk and passive activity loss rules. Chapter 11

• Applicability of net operating loss rules that would allow John to benefit from an
NOL carryback or carryforward. Chapter 7

6. The tax liability in the year of the premature disposition is increased by the difference
between the tax credit for rehabilitation expenditures that was taken and the credit that is
allowed based on the actual holding period. The same treatment applies in those cases
when an asset ceases to be qualified property. p. 12-8

7. The work opportunity tax credit was enacted to encourage employers to hire individuals
from one or more of a number of targeted economically disadvantaged groups. The
taxpayer hiring the members of the targeted group benefits by qualifying for the credit.
Examples of such targeted persons include qualified ex-felons, high-risk youths, food
stamp recipients, summer youth employees, veterans, and persons receiving certain
welfare benefits. pp. 12-8 and 12-9

8. The welfare-to-work credit was enacted to encourage employers to hire individuals who
have been long-term recipients of family assistance welfare benefits. Unlike the work
opportunity credit, which is available for wages paid in the first year of employment
only, the welfare-to-work credit is available for qualifying wages paid to eligible
individuals during the first two years of employment.

The credit is equal to 35% of the first $10,000 of qualified wages paid to an employee in
the first year of employment, plus 50% of the first $10,000 of qualified wages in the
second year of employment.

pp. 12-9 and 12-10

9. The research activities credit is intended to encourage research and experimentation in


the United States. The qualifying expenditures incurred, usually described as research
and development (R & D) expenditures, give rise to the credit, which is the sum of two
components: an incremental research activities credit and a basic research activities
credit. pp. 12-10 to 12-12

10. Changes qualifying for the disabled access credit must involve the removal of
architectural, communication, physical, or transportation barriers that otherwise could
make a business inaccessible to disabled or handicapped individuals. Examples of
qualifying projects include installing ramps, widening doorways, and adding raised
markings on elevator control buttons. Note that the building must originally have been
placed in service before November 6, 1990 for the expenditures to qualify for the credit.
p. 12-13

11. Yes, the earned income credit is a form of a negative income tax because it is a
refundable credit even for taxpayers who do not have any income tax liability. p. 12-15

12. In general, the earned income credit is available to individuals whose income is below
certain thresholds. For example, the earned income credit may be claimed by taxpayers
who have a qualifying child or children in their home and whose earned income or AGI
does not exceed the thresholds listed in Table 12-2. In addition, the credit is available to
taxpayers ages 25 through 64 who have no qualifying children and who cannot be
12-6 2006 Comprehensive Volume/Solutions

claimed as a dependent on another taxpayer’s return. For these situations, the credit is
available even though a qualifying child is not living with the taxpayer, but it is not
available after the taxpayer’s income exceeds the thresholds listed in Table 12-2. pp.
12-15 to 12-17 and Table 12-2

13. The base amount, which depends on filing status, is reduced dollar for dollar by Social
Security payments. Therefore, a taxpayer who receives Social Security payments equal
to or greater than the base amount will not receive any benefit from this tax credit.
pp. 12-17 and 12-18

14. The purpose of the overall limitation on the foreign tax credit is to prevent foreign taxes
from offsetting taxes on U.S.-source income. Because U.S. income tax rates are
relatively low compared to historical norms, many foreign tax rates are higher causing
this limitation to play an important role. p. 12-19

15. • The optimal combination of using the foreign earned income exclusion, the deduction
for foreign income taxes paid, and the foreign tax credit. p. 12-19, and Chapters 5
and 10

• The application of the passive activity loss rules to any potential loss generated on the
rental of her home. Chapter 11

• Calculation of the amount and nature of gain or loss realized and recognized on the
sale of major tangible assets such as her automobile. Chapters 3 and 13

• Potential deductibility of employee expenses incurred in conjunction with her


overseas assignment such as travel and transportation expenses. Chapter 9

16. In 2005, up to $10,630 ($10,390 in 2004) of nonrecurring costs directly associated with
the adoption process of an eligible child, such as legal costs, adoption fees, social service
review costs, and transportation costs, qualify for the credit. An eligible child is one who
is:

• under 18 years of age at the time of the adoption, or

• physically or mentally incapable of taking care of himself or herself.

An individual claims the adoption expenses credit in the year expenses were paid or
incurred if the expenses were paid during or after the year in which the adoption was
finalized. For expenses paid or incurred in a year prior to when the adoption was
finalized, the credit must be claimed in the tax year following the tax year during which
the expense is paid or incurred. The amount of the credit that is otherwise available is
phased-out for taxpayers whose AGI (modified for this purpose) exceeds $159,450 (in
2005 and it is totally eliminated when the AGI reaches $199,450. In 2004, the phaseout
began when AGI exceeded $155,860.

The credit is a nonrefundable credit and is available to taxpayers only in a year in which
this credit and the other nonrefundable credits do not exceed the taxpayer’s tax liability.
However, any unused adoption expenses credit may be carried over for up to five years,
being utilized on a first-in first-out basis.

p. 12-20
Tax Credits 12-7

17. The child tax credit is available to individual taxpayers based solely on the number of
qualifying children under age 17 and does not depend on the taxpayer working or seeking
employment. The maximum credit equals $1,000 per qualifying child. The credit is
phased-out for taxpayers having AGI in excess of specified thresholds. The credit for
child and dependent care expenses is available to taxpayers who incur employment-
related expenses for a child under age 13 or dependent care. The credit for child and
dependent care expenses is computed as a percentage of qualifying child and dependent
care expenses (20% to 35%, depending on the taxpayer’s AGI). The amount the rate is
applied to is subject to statutory ceilings of (1) the lower earned income of the taxpayer
or spouse and (2) the lesser of actual child and dependent care expenses or $250 per
month for one qualifying child or dependent or $500 per month for two or more
qualifying children or dependents. pp. 12-21 to 12-23

18. The credit is allowed for child care expenses incurred on behalf of a child under the age
of 13 that enable the taxpayer to work or seek employment. Gail is deemed to be fully
employed for each month that she is a full-time student (the entire year in this case) and
to have earned $250 for each such month. Because their child is under age 13, Gary and
Gail are eligible for the credit if they incur eligible expenses and comply with the
reporting requirements. pp. 12-22, 12-23, and Example 30

19. If Polly’s and Leo’s AGI is $70,000, they would save income taxes by taking advantage
of the plan because income taxes would be avoided on the $3,500 in salary "given-up,"
and the reimbursement of child care expenses would be excludible from gross income.
Alternatively, if Polly does not take advantage of the plan, her income taxes will be $275
higher than they otherwise would be.

Salary $3,500
Income tax rate X 25%
Income tax on salary $ 875
Credit for child and dependent care expenses ($3,000 X 20%) (600)
Net income tax $ 275

In addition, to the extent Polly participates in the plan, her FICA taxes will be reduced by
$267.75 ($3,500 X 7.65%), given that her salary does not exceed $90,000 in 2005.

Alternatively, if their AGI were $14,000, Polly and Leo would benefit more by utilizing
the credit for child and dependent care expenses rather than participating in the
dependent care reimbursement plan. Specifically, such a strategy would generate a credit
that would not only offset the taxes on the $3,500 of income, but $432 would be available
to offset Polly’s and Leo’s tax liability on their remaining income.

Salary $3,500
Income tax rate X 10%
Income tax on salary $ 350
Plus: FICA tax on $3,500 ($3,500 X 7.65%) 268
Total taxes $ 618
Less: Credit for child and dependent care expenses ($3,000 X 35%) (1,050)
Net tax savings $ 432

p. 12-23
12-8 2006 Comprehensive Volume/Solutions

20. Various income exclusions, deductions, and tax credits are available in the tax law to
help make college more affordable, particularly for low- to middle-income taxpayers.
The list of provisions that provide such benefits include the following:

• Two education tax credits are available to help offset the cost of a college education.
These credits are the HOPE scholarship credit and the lifetime learning credit.
pp. 12-23 to 12-25

• Educational savings bonds. (Chapter 5)

• Qualified tuition programs. (Chapter 5)

• Scholarships. (Chapter 5)

• The deduction for interest paid on student loans. (Chapter 6)

• Qualified tuition and related expenses under § 222. (Chapter 9)

• Coverdell Education Savings Accounts (CESAs).

• Penalty-free withdrawals from traditional IRAs to pay for qualifying educational


expenses.

21. The credit for small employer pension plan startup costs is available for small employers
who incur administrative costs associated with establishing and maintaining certain
qualified plans. By allowing the credit, the after-tax cost to the employer of establishing
a retirement plan for its employees is reduced. Congress expects that the availability of
the credit will encourage employers to establish qualified plans for their employees.
p. 12-14

The credit for certain retirement plan contributions (the “saver’s credit”) is available to
encourage lower- and middle-class taxpayers to contribute to qualified retirement plans.
The benefit provided by this credit is in addition to any deduction or exclusion that
otherwise is available due to the qualifying contribution. As one’s AGI increases, the
rate applied to the contributions in calculating the credit is reduced and once the
taxpayer’s AGI exceeds the upper end of the applicable range, no credit is available. p.
12-25

22. a. Tax credit for rehabilitation expenditures. The credit is based on expenditures
incurred to rehabilitate industrial and commercial buildings and certified historic
structures. It is intended to discourage businesses from moving from older,
economically distressed areas to newer locations and to encourage the
preservation of historic structures. p. 12-7

b. Low-income housing credit. The credit is designed to encourage building owners


to make affordable housing available for low-income individuals. p. 12-12

c. Research activities credit. The research activities credit is intended to encourage


research and experimentation in the United States. p. 12-10

d. Earned income credit. This credit has been justified as a means of providing tax
equity to the working poor. It is intended to help offset the regressive taxes that
are a part of our tax system, such as the gasoline excise tax and the FICA tax. In
Tax Credits 12-9

addition, it is designed to encourage economically disadvantaged individuals to


become contributing members of the workforce. p. 12-15
e. Foreign tax credit. The purpose of the foreign tax credit is to mitigate the double
taxation that results when income earned in a foreign country is subject to both
U.S. and foreign taxes. p. 12-19

PROBLEMS

23. Carol’s allowable general business credit for the current year is limited to $25,000,
determined as follows:

Net income tax $125,000*


Less: The greater of:
$100,000 (tentative minimum tax)
$25,000 [25% X ($125,000 – $25,000)] (100,000)
Amount of general business credit allowed $ 25,000

*Net income tax = $125,000 (regular tax liability) + $0 [alternative minimum tax
($100,000 tentative minimum tax – $125,000 regular tax liability)] – $0 (nonrefundable
credits).

p. 12-6 and Example 7

24. 2005 general business credit $45,000


Total credit allowed (based on tax liability) $80,000
Less: Utilization of carryovers on FIFO basis
2001 (5,000)
2002 (15,000)
2003 (5,000)
2004 (20,000)
Remaining credit allowed $35,000
Applied against
2005 general business credit (35,000)
2005 unused amount carried forward to 2006 $10,000
Therefore, the sources of the $80,000 general business credit allowed in 2005 are the
carryovers of $45,000 from the four previous years and $35,000 of the $45,000 general
business credit generated in 2005.

Because unused credits may be carried over for up to 20 years, the carryovers from each
of the four previous years may be utilized.

p. 12-6 and Example 8

25. a. The rehabilitation expenditures credit is 10% of $250,000, or $25,000.

b. Cost recovery of building $4,487


[$200,000 – $25,000 (land)] X 2.564%

Plus: Cost recovery of improvements

Cost of improvements $250,000


Less: Rehabilitation expenditures credit (25,000)
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Depreciable basis $225,000

Cost of recovery of improvements 1,204


($225,000 X 0.535%)

Total cost recovery for the year $5,691

pp. 12-7, 12-8, and Chapter 8

26. a. The work opportunity tax credit for the year is as follows:
3 qualified employees X $6,000 limit on wages for each employee
X 40% $ 7,200
3 qualified employees X $4,000 wages for each employee X 25% 3,000
Total work opportunity tax credit $10,200

b. $109,800 [$120,000 (total wages) – $10,200 (credit)].

pp. 12-8, 12-9, and Example 11

27. a. The welfare-to-work credit for 2005 is calculated as follows: 3 qualified


employees X $10,000 limit on wages for each employee X 35% $10,500
The welfare-to-work credit for 2006 is calculated as follows: 1 qualified
employee in second year of employment X $10,000 limit on wages
per employee X 50% $ 5,000

The welfare-to-work credit is not available with respect to the compensation paid
to Cassie because she was hired after December 31, 2005.

b. The wage deduction for 2005 is $314,500 [$325,000 (total wages) – $10,500
(credit)]. Wage deduction for 2006 is $337,000 [$342,000 (total wages) – $5,000
(credit)].

p. 12-10 and Example 13

28. a. Qualified research expenditures for the year $50,000


Less: Base amount (35,000)
Incremental research expenditures $15,000
Tax credit rate X 20%
Incremental research activities credit $ 3,000

pp. 12-10, 12-11, and Example 15

b. The tax benefit of Michael’s choices is determined as follows:

Choice 1 Reduce the deduction by 100% of the credit and claim the full
credit.

$50,000 (qualified expenditures) – $3,000 (credit) $47,000


Tax rate X 25%
Tax benefit of reduced deduction $11,750
Plus: Allowed credit 3,000
Total tax benefit of Choice 1 $14,750
Tax Credits 12-11

Choice 2 Claim the full deduction and reduce the credit by the product of
100% of the credit times 35% (the maximum corporate rate).

Deduction (qualified expenditures) $50,000


Tax rate X 25%
Tax benefit of full deduction $12,500
Plus: Reduced credit: $3,000 – [(100% X $3,000) X 35%] 1,950
Total tax benefit of Choice 2 $14,450

Thus, Choice 1 provides Michael a greater tax benefit. pp. 12-10, 12-11, and
Example 16

29. Willis, Hoffman, Maloney, and Raabe, CPAs


5191 Natorp Boulevard
Mason, OH 45040

September 30, 2005

Mr. Ahmed Zinna


16 Southside Drive
Charlotte, NC 28204

Dear Mr. Zinna:

This letter is in response to your inquiry regarding the tax consequences of the proposed
capital improvement projects at your Calvin Street and Stowe Avenue locations.

As I understand your proposal, you plan to incur certain expenditures that are intended to
make your restaurants more accessible to disabled individuals in accordance with the
Americans with Disabilities Act. The capital improvements that you are planning (e.g.,
ramps, doorways, and restrooms that are handicapped accessible) qualify for the disabled
access credit if the costs are incurred for a facility that was placed into service before
November 6, 1990. Therefore, only those projected expenditures of $8,500 for your
Stowe Avenue location qualify for the credit. In addition, the credit is calculated at the
rate of 50% of the eligible expenditures that exceed $250 but do not exceed $10,250.
Thus, the maximum credit in your situation would be $4,125 ($8,250 X 50%). You
should also be aware that the basis for depreciation of these capital improvements would
be reduced to $4,375, the amount of the expenditures of $8,500 reduced by the amount of
the disabled access credit of $4,125. The capital improvements that you are planning for
your Calvin Street location, even though not qualifying for the disabled access credit,
may be depreciated.

Should you need more information or need to clarify the information in this letter, please
call me.
Sincerely,

Raymond Cook, CPA


Partner
pp. 12-13 and 12-14
12-12 2006 Comprehensive Volume/Solutions

30. a. Eduardo is not eligible for the earned income credit because he does not have a
qualifying child and is too young (i.e., must be at least age 25) to qualify for the
credit that is available when the taxpayer does not have a qualifying child.

b. Kate is eligible because she has a qualifying child and her earned income and
AGI are below the disqualifying thresholds.
c. Keith and Susan are not eligible for the earned income credit because they do not
have a qualifying child, and their income exceeds the disqualifying threshold for
the credit that is available when there is not a qualifying child.

d. Even though George does not have a qualifying child, he is eligible for the credit
because he is between 25 and 64 years of age, cannot be claimed as a dependent
on another taxpayer’s return, and has earnings that do not exceed the
disqualifying threshold.

pp. 12-15 to 12-17

31. Gross income (earnings) $19,500


Less: Deduction for AGI (traditional IRA) (500)
Adjusted gross income $19,000

Maximum credit available for 2005 for two or more children $4,400
($11,000 X 40%)
Less: Credit phase-out
Earned income* $19,500
Threshold (14,370)
Excess $ 5,130
Phase-out rate X 21.06% (1,080)
Available earned income credit for Vern $3,320

*Earned income ($19,500) is greater than AGI ($19,000).


pp. 12-15, 12-16, Table 12-2, and Example 22

32. a. Maximum credit available for 2005 for two children $4,400
($11,000 X 40%)
Less: Credit phase-out
Earned income $32,000
Threshold (14,370)
Excess $17,630
Phase-out rate X 21.06% (3,713)
Available earned income credit for Joyce $ 687
Table 12-2 and Example 22
b. Keeps Takes
old job new job
Tax calculation:
Salary $32,000 $36,000
Less: Standard deduction* (7,300) (7,300)
Personal and dependency exemptions
($3,200 X 3) (9,600) (9,600)
Taxable income $15,100 $19,100
Tax Credits 12-13

Income tax (based on tax rate schedule)* $ 1,743 $ 2,343


Less: Earned income credit (687) (-0-)
Net tax due $ 1,056 $ 2,343
After-tax cash-flow:
Salary $32,000 $36,000
Less: Net tax due (1,056) (2,343)
After-tax cash-flow $30,944 $33,657
* Joyce qualifies for head of household status.

Based on the calculations above, even though Joyce will not qualify for the
earned income credit and even though her Federal income taxes will increase by
$1,287 ($2,343 – $1,056) if she takes the new job, her net cash-flow will increase
by $2,713 ($33,657 – $30,944). Therefore, based on these quantitative factors
alone, Joyce should probably accept the new job offer.
pp. 12-15, 12-16, and Chapter 3
33. Base amount (married filing jointly; both 65 or older) $7,500
Less: Social Security benefits $4,000
(AGI over $10,000) X 1/2
($10,500 – $10,000) X 1/2 250 (4,250)
Balance subject to credit $3,250
Tax credit rate X 15%
Tax credit for the elderly (subject to tax liability limitation) $ 488

Unfortunately for Roger and Thelma, they may not claim the $488 tax credit for the
elderly in 2005 because of the tax liability limitation (i.e., their income tax liability is $0
before considering the credit).

Gross income ($8,000 + $2,500) $10,500


Less: Regular standard deduction $10,000
Additional standard deduction for taxpayers
65 years of age or older ($1,000 + $1,000) 2,000
Personal exemptions ($3,200 X 2) 6,400 (18,400)
Taxable income $ -0-
Income tax liability $ -0-
Therefore, because the tax credit for the elderly is nonrefundable and they have no
income tax liability, they may not claim any benefit from this credit.

pp. 12-17, 12-18, Table 12-3, and Example 24

34. a. $50,000 (Foreign source TI) X $18,330** (U.S. tax) $ 7,901


$116,000 (Worldwide TI)*
Total foreign taxes paid $26,000
Foreign tax credit: [lesser of $7,901 (foreign tax credit limitation)
or $26,000 (foreign taxes paid)] $ 7,901
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*$100,000 + $16,000 [5 X $3,200 (personal and dependency exemptions not


allowed)].
**Tax on $100,000 = $18,330 per Tax Rate Schedule for 2005.

Kim’s net U.S. income tax payable = $18,330 – $7,901 (foreign tax credit) =
$10,429.

b. While it is true that all foreign income taxes paid are available to offset a
taxpayer’s U.S. income tax liability on worldwide income, in any current year the
overall limitation effectively allows only the amount of foreign taxes that is equal
to the foreign-source taxable income’s proportionate share of the U.S. income tax
liability (before the foreign tax credit) in relation to the total worldwide taxable
income. Thus, in part a. of this problem, a $18,099 carryback or carryforward is
created [$26,000 (foreign taxes paid) – $7,901 (current benefit of the foreign tax
credit)] because Kim is not able to offset fully the foreign taxes paid against the
U.S. income tax liability. Even though the one-year carryback and ten-year
carryforward provision exists to provide relief, it is unlikely that Kim would
benefit assuming the relative income levels and tax rates remain the same in the
future. Therefore, if Kim moves his novelty goods business to a lower tax
jurisdiction, the projected foreign income taxes that would be due could be fully
used to offset the U.S. income tax liability on worldwide income and not be
limited by the overall limitation. Further, generation of foreign source income at
a foreign tax less than the U.S. tax could create an excess credit limitation for
Kim; thus, he could use the carryover of the foreign tax credit generated by the
high tax country. Consequently, moving his business as he contemplates could
produce significant savings to Kim.

p. 12-19 and Example 25

35. a. $150,000 (Foreign-source TI) X $170,000 (U.S. tax) $51,000


$500,000 (Worldwide TI)
Foreign tax credit overall limitation $51,000
Total foreign income taxes paid $45,000
Foreign tax credit allowed: [lesser of $51,000 (foreign tax credit
limitation) or $45,000 (foreign taxes paid)] $45,000
Blue Corporation’s Federal income tax, net of the foreign tax credit, is $125,000
($170,000 – $45,000). Since the U.S. tax rates are higher than the foreign tax
rates, the overall limitation does not apply.

b. The amount of the foreign tax credit carryback and carryover is $0.

p. 12-19 and Example 25


36. a. Ann and Bill must claim the adoption expenses credit in 2005 ($4,000 + $6,630,
limited to $10,630), since they paid or incurred qualified adoption expenses prior
to the year in which the adoption was finalized and in the year finalized. In their
particular case, they may take the credit in 2005 for $10,630. The amount of
expenses paid in excess of $10,630 is a nondeductible personal expense. Further,
Tax Credits 12-15

because their modified AGI is less than $159,450, the amount of the credit
otherwise available is not reduced.

b. $6,498 = $10,630 – {$10,630 X [($175,000 – $159,450) ÷ $40,000]}.

p. 12-20 and Examples 26 and 27

37. a. Durell and Earline may only claim the child tax credit for their two children, ages
5 years and 6 months. The full amount of the child tax credit is available for
qualifying children born during the tax year. Although Earline’s son from a
previous marriage is claimed as a dependent, he is not eligible for the child tax
credit since he is not under age 17. Since Durell and Earline’s combined AGI is
below $110,000, their child tax credit is $2,000 ($1,000 X 2).

b. Since Durell and Earline’s combined AGI exceeds $110,000, the maximum child
tax credit of $2,000 must be reduced. The credit reduction is computed as $50 for
each $1,000 of AGI or fraction thereof exceeding the threshold amount.

AGI $119,000
Threshold amount (110,000)
Excess $ 9,000

$9,000 X $50 = $450 reduction.


$1,000

Durell and Earline’s child tax credit is $1,550 ($2,000 maximum credit – $450
reduction) for the year.
p. 12-21 and Example 28

38. The earned income ceiling does not apply since Kevin, as a full-time student, is deemed
to have earned $3,000 ($250 X 12 months) and only $2,900 was paid for child care.
Also, Sara is a qualified care provider. Though a related party, she is not Kevin and
Jane’s child who is under age 19.

In terms of the AGI effect on the rate, the applicable rate for the credit is 24%.
Consequently, a credit of $696 (24% X $2,900) is allowed.

pp. 12-21, 12-22, and Examples 29 and 30

39. For two children, the maximum expense for purposes of the credit for child and
dependent care expenses is $6,000. However, since the qualifying expenditures are
limited to the earnings of the lesser paid spouse (i.e., $5,000), this amount is used in
calculating the credit. Using the combined AGI of $27,500 ($22,500 + $5,000), the
applicable rate for the credit is 28%. Thus, the credit is $1,400 (28% X $5,000).

The fact that the care was provided by Ralph’s mother is of no consequence as she is not
Ralph or Jill’s child.

pp. 12-21, 12-22, and Example 30

40. a. Bernadette is eligible to take the lifetime learning credit for her son’s tuition costs
and the tuition expenses for her continuing professional education seminars. The
costs for books incurred both by Bernadette and her son are ineligible for the
12-16 2006 Comprehensive Volume/Solutions

credit. The lifetime learning credit is available per taxpayer on the first $10,000
of qualifying tuition expenses. Accordingly, her son’s tuition ($8,200) plus up to
$1,800 of her tuition would qualify for the credit during 2005. Therefore,
Bernadette’s maximum lifetime learning credit would be $2,000 (20% X $10,000)
for 2005. However, the $2,000 maximum credit would have to be reduced by
$800 since her $95,000 AGI exceeds the threshold level of $87,000 for married
taxpayers.

[($95,000 – $87,000)/$20,000] X $2,000 = $800 reduction

Maximum credit $2,000


Less: Phaseout (800)
Education credit $1,200

The portion of the costs associated with the continuing education seminars that
are not used in the lifetime learning credit calculation may qualify as employee
business expenses, deductible as education expenses (see Chapter 9).

pp. 12-23, 12-24, and Examples 32 and 33

b. “How the Tax Law Can Help Pay for College and Continuing Professional
Education” Outline for Presentation to Rotary Club

I. Introduction.
A. Many tax provisions are available to help defray the cost of both
college and continuing professional education.
B. Complicated area of tax law so planning ahead is important.

II. Tax provisions that help pay for college.


A. Contributions to Coverdell Educational Savings Accounts
(CESAs).
B. Penalty-free withdrawals to pay for college from traditional IRAs.
C. Participation in qualified tuition programs for tuition and room and
board costs. (Chapter 5)
D. Deductibility of student-loan interest. (Chapter 10)
E. Purchase of Series EE educational savings bonds. (Chapter 5)
F. Education tax credits—HOPE scholarship credit and lifetime
learning credit. (Chapter 12)
G. Employer-provided educational assistance programs. (Chapter 5)
H. Scholarships exempt from taxation. (Chapter 5)
I. The limited deduction for qualified tuition and related expenses.
(Chapter 9)

III. Tax provisions that help pay for continuing education.


A. Lifetime learning credit. (Chapter 12)
B. Employer-provided educational assistance programs. (Chapter 5)
C. Deductibility of expenses ineligible for credit or assistance
program. (Chapter 9)

IV. Income limitations and interaction among various provisions also are
important issues. (Chapter 12)

41. a. Kathleen and Glenn’s contributions to their respective § 401(k) plans are
qualified contributions; however, the maximum amount that may be considered in
Tax Credits 12-17

calculating the credit is $2,000 for each taxpayer. In addition, because their AGI
is $32,000, the rate of the credit is 20%. Therefore, the credit available to
Kathleen and Glenn is $800 [($2,000 X 2) X 20%]. Example 34

b. Joel may not claim the credit for certain retirement plan contributions because he
is less than 18 years of age and claimed as a dependent on his parents’ return.
p. 12-25

CUMULATIVE PROBLEMS
42. Wade’s net business ($280,000 – $200,000) $ 80,000
Jane’s salary 160,000
Interest income 8,000
Gross income $248,000
Less: Deductions for AGI
Capital losses (Note 1) $3,000
One-half of self-employment tax (Note 5) 5,652 (8,652)
Adjusted gross income $239,348
Less: Itemized deductions (Note 2) (24,098)
Personal and dependency exemptions
(Wade, Jane, Sean, and Debra) (Note 3) (10,496)
Taxable income $204,754

Computation of net tax payable or refund due

Tax from Tax Rate Schedule on $204,754 (Note 4) $48,160


Plus: Self-employment tax (Note 5) 11,304
Total tax $59,464
Less: Prepayments and credits
Income tax withheld $29,000
Estimated tax payments 30,000
Credit for child and dependent care expenses
(Note 6) 600 (59,600)
Net tax payable (or refund due) ($ 136)
Notes
(1) Capital asset transactions:
Short-term capital loss ($8,000 – $10,000) $2,000
Long-term capital loss ($4,800 – $6,000) 1,200
Total capital loss $3,200

Capital loss deduction limitation $3,000

See Chapters 3 and 14.

(2) Itemized deductions $26,900


Plus: Miscellaneous itemized deductions limited
to excess over 2% of AGI:
(2% X $239,348 = $4,787)
Travel expenses excluding meals $ 800
Meals and entertainment ($800 X 50%) 400
$1,200 -0-
12-18 2006 Comprehensive Volume/Solutions

Itemized deductions before reduction $26,900


Less: Itemized deduction reduction amount
[($239,348 – $145,950) X 3%] (2,802)
Itemized deductions, net of reduction $24,098

(3) Personal and dependency exemptions ($3,200 X 4) $12,800


Less: Phase-out
AGI before phase-out $239,348
– Statutory threshold amount (218,950)
Excess $ 20,398
÷ Statutory amount 2,500
Result 8.16
Rounded 9
X Statutory percentage 2%
= Percentage 18%

Amount of personal and dependency exemption deduction:

[(1 – .18) X $12,800] $10,496

(4) Tax on $182,800 $40,915


Tax on $21,954 ($204,754 – $182,800) at 33% 7,245
Total income tax $48,160

(5) The net earnings from self-employment are $80,000 ($280,000 – $200,000).
Therefore, using the format presented in Figure 12-1 in the text, the self-
employment tax is computed as follows:

(1) Net earnings from self-employment $80,000


(2) Multiply line (1) by 92.35% $73,880
(3) If the amount on line 2 is $90,000 or less, multiply
the line 2 amount by 15.3%. This is the self-
employment tax. $11,304

Thus, the deduction for AGI is $5,652 ($11,304 X 50%).

(6) The credit for child and dependent care expenses is limited to 20% of $3,000 (the
maximum qualifying for one child), or $600. The 16 year-old child does not
qualify, due to the under age 13 limitation.

43. Gross income:


Salary $63,000
Interest income ($1,300 + $400) 1,700
Dividend income ($500 + $400 + $1,200) 2,100
State income tax refund 1,600
Business income (Note 1) 19,800
Net STCG (Note 2) 1,100
Total gross income $89,300
Deductions for AGI:
Business expenses (Note 1) (16,750)
One-half of self-employment tax (Note 3) (216)
Adjusted gross income $72,334
Tax Credits 12-19

Deductions from AGI:


Itemized deductions (Note 4) (9,868)
Personal exemption (3,100)
Taxable income $59,366

Income tax (Note 5) $11,371


Self-employment tax (Note 3) 431
Total tax $11,802
Taxes withheld (11,000)
Estimated taxes (1,000)
Net tax payable (or refund due) for 2004 ($ 198)

See the tax return solution beginning on page 12-21 of the Solutions Manual.

Notes

(1) Business receipts


Part-time tax practice revenues $ 3,800
Software writing business royalties 16,000
Total gross income $19,800
Business expenses
Part-time tax practice processing fee $ 600
Software writing business ($7,000 + $2,000 + $3,000 +
$650 + $3,500) 16,150
Total business expenses (deducted for AGI) $16,750

(2) Gray stock ($7,000 – $8,800) STCL ($1,800)


Utility vehicle ($3,400 – $3,000) STCG 400
Blue stock ($5,500 – $3,000) STCG 2,500
Net STCG $1,100

(3) Beth’s earnings from self-employment during 2004 were $3,050 ($19,800 –
$16,750) and the self-employment tax on this amount is computed as follows:

Social Security Medicare


Portion Portion
Ceiling amount $87,900
Less: FICA wages (63,000)
Net ceiling $24,900

Net self-employment income ($3,050 X 92.35%) $ 2,817 $2,817

Lesser of net ceiling or net self-employment income* $ 2,817 $2,817


Tax rate X 12.4% X 2.9%
Self-employment tax $ 349 $ 82

Total self-employment tax $431

Therefore, one-half of the self-employment tax, or $216, is deductible for AGI.

*All of Beth’s net self-employment earnings are subject to the Medicare portion
of the self-employment tax of 2.9%.
12-20 2006 Comprehensive Volume/Solutions

(4) Medical expenses [($300 + $2,875) – (7.5% X $72,334)] $ -0-


Taxes ($1,954 + $1,766) 3,720
Home mortgage interest 3,845
Charitable contributions ($1,560 + $520) 2,080
Miscellaneous itemized deductions
Professional dues and subscriptions $ 350
Convention expenses, excluding meals 1,220
Meals ($200 X 50%) 100
$1,670
Less: 2% of AGI ($72,334 X 2%) (1,447) 223
Itemized deductions $9,868

(5) Tax on taxable income of $59,366


Tax on dividend income ($2,100 X 15%) $ 315
Tax from Tax Table on remaining taxable income of $57,266
($59,366 – $2,100) 11,056
Total income tax $11,371
Tax Credits 12-21

43.
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43. continued
Tax Credits 12-23

43. continued
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43. continued
Tax Credits 12-25

43. continued
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43. continued
Tax Credits 12-27

43. continued
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43. continued
Tax Credits 12-29

43. continued
12-30 2006 Comprehensive Volume/Solutions

43. continued
Tax Credits 12-31

43. continued
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43. continued
Tax Credits 12-33

43. continued

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