chapter 11 tax credits solutions to …isu.indstate.edu/acharmo/smpdf/ch11.pdfchapter 11 tax credits...

CHAPTER 11

TAX CREDITS

SOLUTIONS TO PROBLEM MATERIALS Status: Q/P Question/ Present in Prior Problem Topic Edition Edition

1 Tax credit versus deduction Unchanged 12 Refundable versus nonrefundable credits Unchanged 23 Priority of credits in offsetting tax liability Unchanged 34 Components of general business credit New 5 Issue ID Unchanged 56 Issue ID New 7 Work opportunity tax credit Unchanged 78 Welfare-to-work credit Unchanged 89 Research expenditures tax credit and deduction Unchanged 9

10 Disabled access credit New 11 Earned income credit New 12 Tax credit for elderly or disabled taxpayers Unchanged 1213 Foreign tax credit: qualifying taxes New 14 Foreign tax credit versus foreign earned income

exclusion Unchanged 14

15 Issue ID Unchanged 1516 Adoption expenses credit: calculation Unchanged 1617 Child tax credit versus credit for child and

dependent care expenses Unchanged 17

18 Credit for child and dependent care expenses Unchanged 1819 Credit for child and dependent care expenses

versus reimbursement plan Modified 19

20 Education tax credits Unchanged 2021 Incentive effects of credit for small employer

pension plan startup costs and credit for certain retirement plan contributions

Unchanged 22

11-1

11-2 2004 Comprehensive Volume/Solutions Manual

Status: Q/P Question/ Present in Prior Problem Topic Edition Edition

22 Rationale for various credits New * 23 Limitation on general business credit for individuals New * 24 Use of general business credit carryovers Unchanged 24

25 Certified historic structure tax credit for rehabilitation expenditures

New

26 Work opportunity tax credit Unchanged 26* 27 Welfare-to-work credit Modified 27* 28 Incremental research activities credit Unchanged 28

29 Disabled access credit Unchanged 2930 Earned income credit New

* 31 Earned income credit New * 32 Earned income credit Unchanged 32* 33 Tax credit for elderly or disabled taxpayers Unchanged 33* 34 Foreign tax credit Unchanged 34* 35 Foreign tax credit Unchanged 35

36 Adoption expenses credit Unchanged 3637 Child tax credit Unchanged 3738 Credit for child and dependent care expenses New 39 Credit for child and dependent care expenses:

student spouse, payments to relatives Modified 39

40 Education tax credits New 41 Credit for certain retirement plan contributions Unchanged 41

* 42 Cumulative Modified 42* 43 Cumulative Modified 43 *The solution to this problem is available on a transparency master.

Tax Credits 11-3

CHECK FIGURES 23. $5,000. 24. Credit allowed $320,000; credit

carried forward $40,000. 25. With a $400,000 expenditure: the

credit equals $80,000, depreciable basis of building equals $570,000.

26.a. $10,200. 26.b. $109,800. 27.a. 2003 $10,500; 2004 $5,000. 27.b. 2003 $314,500; 2004 $337,000. 28.a. $1,440. 28.b. Taking the reduced deduction and

the full credit provides the greater benefit.

29. Credit available of $4,375. 30.a. Not eligible. 30.b. Eligible. 30.c. Not eligible. 30.d. Eligible. 31. $2,424. 32.a. $778. 32.b. Joyce should probably accept the job

offer (cash flow of $29,200 for old job; $31,822 for new job).

33. Credit available of $412 prior to the limitation; limited to $120 tax liability.

34.a. Foreign tax credit $8,983; income tax payable $11,723.

34.b. Moving the business could produce significant savings to Kim.

35. $612.5 million. 36.a. $10,160. 36.b. $4,417. 37.a. $1,200. 37.b. $750. 38. $1,200. 39. $525. 40. $875. 41.a. Credit available $800. 41.b. May not claim credit. 42. Refund due $912. 43. Refund due $665.


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. 11-4 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. p. 11-4 and Exhibit 11-1

3. Because some credits are refundable and others are not and because some credits are subject to carryback and carryover provisions while others are not, it is important to determine the order in which credits are offset against the tax liability. pp. 11-4 and 11-5

4. The general business credit is comprised of the following credits:

• Tax credit for rehabilitation expenditures.

• Business energy credits.

• Work opportunity tax credit.

• Welfare-to-work credit.

• Research activities credit.

• Low-income housing credit.

• Disabled access credit.

• Credit for small employer pension plan startup costs.

• Credit for employer-provided child care.

Exhibit 11-1 5. Among the relevant tax issues are the following:

• Ability to use tax credits currently and the use of suspended credits. pp. 11-4 to 11-6 • 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 10 • The at-risk amount (how the loan guarantee affects the calculation of the at-risk

amount). Chapter 10

Tax Credits 11-5

• Interaction between the at-risk and passive activity loss rules. Chapter 10 • Applicability of net operating loss rules that would allow John to benefit from an

NOL carryback or carryforward. Chapter 6 6. For nonresidential buildings and residential rental property that are not certified historic

structures, a 10% credit is available for rehabilitation expenditures if the building was originally placed in service before 1936. For residential and nonresidential certified historic structures, the credit rate is 20%. The rehabilitation expenditures must exceed the greater of $5,000 or the adjusted basis of the property before the rehabilitation. p. 11-8

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. p. 11-9

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 percent of the first $10,000 of qualified wages paid to an employee in the first year of employment, plus 50 percent of the first $10,000 of qualified wages in the second year of employment. p. 11-10

9. In general, qualified research and experimentation expenditures not only are eligible for

the 20 percent credit, but also may be expensed in the year incurred. In this regard, the taxpayer has two choices:

•

•

Use the full credit and reduce the expense deduction for research expenses by 100 percent of the credit.

Retain the full expense deduction and reduce the credit by the product of 100 percent of the credit times the maximum corporate tax rate (35 percent).

However, as an alternative to claiming an expense deduction immediately, the taxpayer may capitalize the research expenses and amortize them over 60 months or more. In this case, the amount capitalized and subject to amortization is reduced by the full amount of the credit only if the credit exceeds the amount allowable as a deduction. p. 11-11 and Example 16

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. 11-14

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. 11-18 12. The base amount, which depends on filing status, is reduced dollar for dollar by Social

Security benefits received. Therefore, a taxpayer who receives Social Security payments equal to or greater than the base amount will not receive any benefit from the tax credit. pp. 11-18 and 11-19

13. No. Only foreign income taxes, war profits taxes, and excess profits taxes qualify for the

credit. In determining whether the foreign tax is an income tax, U.S. criteria are applied. pp. 11-19 and 11-20

14. In cases where the income tax of a foreign country is higher than the U.S. income tax, use

of the tax credit usually is preferable to use of the exclusion. If, however, the reverse is true, election of the foreign earned income exclusion probably reduces the overall tax burden to a greater extent than using the tax credit. p. 11-27 and Example 35

15. • The optimal combination of using the foreign earned income exclusion, the deduction

for foreign income taxes paid, and the foreign tax credit. p. 11-20 and Chapters 4 and 9

• The application of the passive activity loss rules to any potential loss generated on the

rental of her home. Chapter 10

• 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 2 and 12

• Potential deductibility of employee expenses incurred in conjunction with her overseas assignment such as travel and transportation expenses. Chapter 8

16. In 2003, up to $10,160 ($10,000 in 2002) 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 $152,390 (in 2003) and it is totally eliminated when the AGI reaches $192,390. In 2002, the phaseout began when AGI exceeded $150,000.

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.

Tax Credits 11-7

However, any unused adoption expenses credit may be carried over for up to five years, being utilized on a first-in first-out basis.

pp. 11-21 and 11-22 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 $600 per qualifying child in 2003. 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 child 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% in 2003, 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. 11-22 to 11-24

18. Yes. Although there is a reduction in the applicable rate of credit as AGI increases from

$15,000 to $43,000, the rate for the credit for child and dependent care expenses never drops below 20%. p. 11-23

19. If Polly’s and Leo’s AGI is $50,000, 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 $345 higher than they otherwise would be.

Salary $3,500 Income tax rate X 27% Income tax on salary $ 945 Credit for child and dependent care expenses ($3,000 X 20%) (600) Net income tax $ 345

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 $87,000 in 2003. Alternatively, if their AGI were $20,000, 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 $342 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 32%) (960) Net tax savings $ 342

pp. 11-22 to 11-24


20. The HOPE scholarship credit is available for qualifying tuition expenses paid for the first two years of postsecondary education. Eligible students include the taxpayer, taxpayer’s spouse, and taxpayer’s dependents. The maximum credit available is $1,500 per year per student, computed as 100 percent of the first $1,000 of tuition expenses, plus 50 percent of the next $1,000 of tuition expenses.

The lifetime learning credit is available for qualifying tuition expenses for taxpayers pursuing education beyond the first two years of postsecondary education. Individuals who are completing their last two years of undergraduate studies, pursuing graduate or professional degrees, or otherwise seeking new job skills or maintaining existing job skills are all eligible for the credit. Eligible individuals include the taxpayer, taxpayer’s spouse, and taxpayer’s dependents. The maximum credit is 20 percent of up to $10,000 ($5,000 prior to 2003) of qualifying tuition expenses incurred in the year, and is computed per taxpayer. Both credits are phased-out for higher income taxpayers. pp. 11-25 and 11-26

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. pp. 11-14 and 11-15

The credit for certain retirement plan contributions 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. pp. 11-26 and 11-27

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. 11-7

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

to make affordable housing available for low-income individuals. p. 11-13

c. Research activities credit. The research activities credit is intended to encourage research and experimentation in the United States. p. 11-11

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 addition, it is designed to encourage economically disadvantaged individuals to become contributing members of the workforce. pp. 11-15 and 11-16

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. 11-20

Tax Credits 11-9

f. Business energy credits. Business energy credits are available to encourage the conservation of natural resources and the development of alternative energy sources (to oil and natural gas). The most important business energy credits are the 10% credits for solar energy property and geothermal property. pp. 11-8 and 11-9

PROBLEMS 23. Earl’s allowable general business credit for the year is limited to $5,000, determined as

follows: Net income tax $95,000* Less: The greater of:

$90,000 (tentative minimum tax) $17,500 [25% X ($95,000 – $25,000)] (90,000)

Amount of general business credit allowed $ 5,000 * Net income tax = $95,000 (regular tax liability) + $0 [alternative minimum tax ($90,000 tentative minimum tax – $95,000 regular tax liability)] – $0 (nonrefundable credits). p. 11-6 and Example 7

24. 2003 general business credit $180,000 Total credit allowed (based on tax liability) $320,000 Less: Utilization of carryovers on FIFO basis 1999 (20,000) 2000 (60,000) 2001 (20,000) 2002 (80,000) Remaining credit allowed $140,000 Applied against 2003 general business credit (140,000) 2003 unused amount carried forward to 2004 $ 40,000 Therefore, the sources of the $320,000 general business credit allowed in 2003 are the

carryovers of $180,000 from the four previous years and $140,000 of the $180,000 general business credit generated in 2003.

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. 11-6 and Example 8 25. Willis, Hoffman, Maloney, and Raabe, CPAs

5191 Natorp Boulevard Mason, OH 45040

January 2, 2004 Ms. Diane Lawson 127 Peachtree Drive Savannah, GA 31419


Dear Ms. Lawson: This letter is in response to your questions concerning the availability of the rehabilitation tax credit for expenditures that you plan to incur in the rehabilitation of your qualifying historic structure and their impact on the depreciable basis of the structure. It is our understanding that you purchased the qualifying historic structure for $250,000 (excluding the cost of land) and that you intend to incur rehabilitation expenditures of either $200,000 or $400,000.

The tax law requires that in order for the credit to be available, a taxpayer must substantially rehabilitate the structure. In this case, the requirement calls for you to expend more than $250,000 on rehabilitation charges. Therefore, if you incur rehabilitation expenditures of $200,000, the credit is not available and the depreciable basis of the structure would be $450,000 [$250,000 (original cost) + $200,000 (capital improvements)].

By incurring $400,000 on rehabilitation expenditures, a credit of $80,000 ($400,000 X 20%) would be available. However, the depreciable basis of the property would be reduced to the extent of the available credit. Therefore, the depreciable basis of the building would be $570,000 [$250,000 (original cost) + $400,000 (capital improve-ments) – $80,000 (amount of credit)]. Should you need more information or need to clarify our conclusions, do not hesitate to contact me. Sincerely, Malcolm C. Jones, CPA Partner

January 2, 2004 TAX FILE MEMORANDUM FROM: Malcolm C. Jones, CPA SUBJECT: Ms. Diane Lawson Impact of Rehabilitation Tax Credit Diane Lawson has acquired a qualifying historic structure for $250,000 (excluding the cost of land) with the intention of substantially rehabilitating the building. She inquires as to the availability of the rehabilitation tax credit and its impact on the structure’s depreciable basis, if she incurs either $200,000 or $400,000 of qualifying rehabilitation expenditures.

In order to qualify for the rehabilitation credit, Diane would have to substantially rehabilitate the structure. The substantial rehabilitation requirement provides that a taxpayer must incur rehabilitation expenditures that exceed the greater of (1) the adjusted basis of the property before the rehabilitation ($250,000), or (2) $5,000. Therefore, if Diane chooses to incur only $200,000 on the rehabilitation, this amount would not be enough to qualify as a “substantial rehabilitation” and no credit would be available. The depreciable basis of the property would be the sum of its original cost plus the capital improvements, or $450,000 ($250,000 + $200,000).

Tax Credits 11-11

If Diane incurs $400,000 for the rehabilitation project, a substantial rehabilitation would result. Therefore, the rehabilitation tax credit available to Diane would be $80,000 ($400,000 X 20%). The depreciable basis of the property, which would be reduced by the full amount of the credit, would be $570,000 [$250,000 (original cost) + $400,000 (capital improvements) – $80,000 (amount of credit)].

p. 11-7 and Example 9

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)].

p. 11-9 and Example 11 27. a. The welfare-to-work credit for 2003 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 2004 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, 2003. Currently, the credit is not available for employees hired after 2003.

b. The wage deduction for 2003 is $314,500 [$325,000 (total wages) – $10,500

(credit)]. Wage deduction for 2004 is $337,000 [$342,000 (total wages) – $5,000 (credit)].

p. 11-10 and Example 13 28. a. Qualified research expenditures for the year $30,000 Less: Base amount (22,800) Incremental research expenditures $ 7,200 Tax credit rate X 20% Incremental research activities credit $ 1,440

pp. 11-10, 11-11, and Example 15 b. The tax benefit of Matt’s choices is determined as follows:

Choice 1 Reduce the deduction by 100% of the credit and claim the full credit. $30,000 (qualified expenditures) – $1,440 (credit) $28,560 Tax rate X 27% Tax benefit of reduced deduction $ 7,711 Plus: Allowed credit 1,440 Total tax benefit of Choice 1 $ 9,151


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) $30,000 Tax rate X 27% Tax benefit of full deduction $ 8,100 Plus: Reduced credit: $1,440 – [(100% X $1,440) X 35%] 936 Total tax benefit of Choice 2 $ 9,036 Thus, Choice 1 provides Matt a greater tax benefit. pp. 11-10, 11-11, and Example 16

29. Willis, Hoffman, Maloney, and Raabe, CPAs 5191 Natorp Boulevard Mason, OH 45040

September 30, 2003 Mr. Dan DeRose 333 East Shore Drive

Wyckoff, NJ 07481 Dear Dan:

This letter is in response to your inquiry regarding the tax consequences of the proposed capital improvement projects at your Oak Street and Maple Avenue locations. As I understand your proposal, you plan to incur certain expenditures that are intended to make your business 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 $9,000 for your Maple 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 $4,375 ($8,750 X 50%). You should also be aware that the basis for depreciation of these capital improvements would be reduced to $4,625, the amount of the expenditures of $9,000 reduced by the amount of the disabled access credit of $4,375. The capital improvements that you are planning for your Oak 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 p. 11-14

Tax Credits 11-13

30. a. Kristy does not qualify for the earned income tax credit because she does not have a qualifying child nor is she between the ages of 25 and 64.

b. Kareem qualifies for the earned income credit because he is single and has earned

income of less than $11,230 and is between the ages of 25 and 64. c. Carlos does not qualify for the earned income credit because his earnings of

$35,000 exceed the level at which the credit is phased out (maximum of $29,666 for a taxpayer with one child who does not file a joint return).

d. Floyd and Grace qualify for the earned income credit because they have

qualifying children and their income level is below the level at which the credit is phased out.

pp. 11-15 to 11-18 and Table 11-2

31. Maximum credit available for 2003 for one child ($7,490 X 34%) $2,547 Less: Credit phase-out

Earned income $14,500 Phase-out base (13,730) Excess $ 770 Phase-out rate X 15.98% ( 123) Available earned income credit $2,424 Table 11-2 and Example 22 32. a. Maximum credit available for 2003 for two children $4,204 ($10,510 X 40%) Less: Credit phase-out Earned income $30,000 Threshold (13,730) Excess $16,270 Phase-out rate X 21.06% (3,426) Available earned income credit for Joyce $ 778 Table 11-2 and Example 22 b. Keeps Takes old job new job Tax calculation: Salary $30,000 $34,000 Less: Standard deduction* (7,000) (7,000) Personal and dependency exemptions ($3,050 X 3) (9,150) (9,150) Taxable income $13,850 $17,850 Income tax (based on tax rate schedule)* $ 1,578 $ 2,178 Less: Earned income credit (778) (-0-) Net tax due $ 800 $ 2,178 After-tax cash-flow: Salary $30,000 $34,000 Less: Net tax due (800) (2,178) After-tax cash-flow $29,200 $31,822


* 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 $1,378 ($2,178 – $800) if she takes the new job, her net cash-flow will increase by $2,622 ($31,822 – $29,200). Therefore, based on these quantitative factors alone, Joyce should probably accept the new job offer. pp. 11-15 to 11-17, and Chapter 2

33. Base amount (married filing jointly; both age 65 or older) $7,500

Less: Social Security benefits $1,750 1/2 X (AGI over $10,000) [1/2 X ($16,000 – $10,000)] 3,000 (4,750)

Balance subject to credit $2,750 Rate X 15% Tax credit (subject to tax liability limitation) $ 412 The credit allowed may not exceed the amount of the tax liability of $120. This credit does not qualify for carryback or carryover treatment; therefore, the unused amount is lost. pp. 11-18, 11-19, Table 11-3, and Example 24

34. a. $50,000 (Foreign source TI) X $20,706** (U.S. tax) $ 8,983

$115,250 (Worldwide TI)*

Total foreign taxes paid $26,000 Foreign tax credit: [lesser of $8,983 (foreign tax credit limitation) or $26,000 (foreign taxes paid)] $ 8,983 *$100,000 + $15,250 [5 X $3,050 (personal and dependency exemptions not allowed)]. **Tax on $100,000 = $20,706 per Schedule Y-1 for 2003. Kim’s net U.S. income tax payable = $20,706 – $8,983 (foreign tax credit) = $11,723.

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 $17,017 carryback or carryforward is created [$26,000 (foreign taxes paid) – $8,983 (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 two-year carryback and five-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

Tax Credits 11-15

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.

pp. 11-19, 11-20, and Example 25

35. $1.25 billion (Foreign source TI) X $1.05 billion (U.S. tax) $437.5 million $3 billion (Worldwide TI)

Foreign tax credit overall limitation $437.5 million Total foreign taxes paid $600 million Foreign tax credit allowed: [lesser of $437.5 million (foreign tax credit limitation) or $600 million (foreign taxes paid)] $437.5 million Zinnia Corporation’s Federal income tax, net of the foreign tax credit, is $612.5 million ($1.05 billion – $437.5 million). pp. 11-19, 11-20, and Example 25

36. a. Ann and Bill must claim the adoption expenses credit in 2003 ($4,000 + $6,160,

limited to $10,160), 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 2003 for $10,160. The amount of expenses paid in excess of $10,160 is a nondeductible personal expense. Further, because their modified AGI is less than $152,390, the amount of the credit otherwise available is not reduced.

b. $4,417 = $10,160 – {$10,160 X [($175,000 – $152,390) ÷ $40,000]}. pp. 11-21, 11-22, 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 $1,200 ($600 X 2) for 2003.

b. Since Durell and Earline’s combined AGI exceeds $110,000, the maximum child

tax credit of $1,200 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 $1,000 X $50 = $450 reduction.


Durell and Earline’s child tax credit is $750 ($1,200 maximum credit – $450 reduction) for the year.

p. 11-22 and Example 28 38. For two or more children, the maximum expense allowed in 2003 for purposes of the

credit for child and dependent care expenses is $6,000. This amount is less than the child care expenses paid of $6,300 and the lower earned income of $6,200. Since their combined AGI is more than $43,000, the applicable rate for the credit is 20%. Thus, the credit allowed is $1,200 (20% X $6,000). pp. 11-23 and 11-24

39. 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 $2,100 was paid for child care. Also, Sara is a qualified care provider. Though a related party, she is not Kevin’s and Jane’s dependent. Also, the under 19 age limit applies only to children of the taxpayer.

In terms of the AGI effect on the rate, the applicable rate for the credit is 25%. Consequently, a credit of $525 (25% X $2,100) is allowed in 2003. pp. 11-22 to 11-24, and Examples 29 and 30

40. Colin is able to take education tax credits for both Eliza and Rhett’s schooling since both children are claimed as dependents on Colin’s tax return. Eliza is eligible for the HOPE scholarship credit while Rhett’s expenses are eligible for the lifetime learning credit, since he is beyond the first two years of post-secondary education. Room, board, and book costs are not eligible for the credits.

The maximum HOPE scholarship credit for Eliza’s tuition is $1,500 (100% X first

$1,000 of tuition expenses + 50% of second $1,000 of tuition expenses). The maximum lifetime learning credit for Rhett’s tuition paid during the year is $2,000 (20% X $10,000). Subject to the limitation applicable to higher income taxpayers, the full $2,000 lifetime learning credit is available for Rhett’s expenses since his tuition expenses totaling $12,000 ($6,000 per semester) exceed the current $10,000 ceiling.

Since the education tax credits are phased out for higher income taxpayers, Colin will not

receive the total $3,500 ($1,500 + $2,000) in education credits for Eliza and Rhett’s expenses. The credit reduction is $2,625 [($98,000 AGI – $83,000 threshold)/$20,000 phase-out range X $3,500], resulting in a $875 ($3,500 – $2,625) education credit for 2003.

pp. 11-25, 11-26, and Examples 32 and 33 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 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. 11-26

Tax Credits 11-17

CUMULATIVE PROBLEMS 42. Part 1: Tax Computation Wade’s net business income ($280,000 – $166,000) $114,000

Jane’s salary 130,000 Dividend and interest income 8,000 Gross income $252,000 Less: Deductions for AGI Capital losses (Note 1) $3,000 One-half of self-employment tax (Note 5) 6,921 (9,921) Adjusted gross income $242,079

Less: Itemized deductions (Note 2) (23,823) Personal and dependency exemptions (Wade, Jane, Sean, and Debra) (Note 3) (8,784) Taxable income $209,472

Computation of net tax payable or refund due

Tax from Tax Rate Schedule on $209,472 (Note 4) $ 54,847 Plus: Self-employment tax (Note 5) 13,841 Total tax $ 68,688 Less: Prepayments and credits- Income tax withheld $29,000 Estimated tax payments 40,000

Credit for child and dependent care expenses (Note 6) 600 (69,600)

Net tax payable (or refund due) ($ 912) 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 2 and 13 (2) Itemized deductions $26,900 Plus: Miscellaneous itemized deductions limited to excess over 2% of AGI: (2% X $242,079 = $4,842) Travel expenses excluding meals $ 800 Meals and entertainment ($800 X 50%) 400

$1,200 -0- Itemized deductions before reduction $26,900 Less: Itemized deduction reduction amount [($242,079 – $139,500) X 3%] (3,077) Itemized deductions, net of reduction $23,823


(3) Personal and dependency exemptions ($3,050 X 4) $12,200 Less: Phase-out AGI before phase-out $242,079 – Statutory threshold amount (209,250) Excess $ 32,829 ÷ Statutory amount 2,500 Excess 13.13 Rounded 14% X Statutory percentage 2 = Percentage 28% Amount of personal and dependency exemption deduction [(1 – .28) X $12,200] $ 8,784 (4) Tax on $174,700 $42,676.50 Tax on $34,772 ($209,472 – $174,700) at 35% 12,170.20 Total income tax $54,846.70 (5) The net earnings from self-employment are $114,000 ($280,000 – $166,000).

Therefore, using the format presented in Figure 11-1 in the text, the self-employment tax is computed as follows:

(1) Net earnings from self-employment $114,000.00 (2) Multiply line (1) by 92.35% $105,279.00 (3) Multiply the excess of line 2 over $87,000 by 2.9% and add $13,311. This is the self-employment tax. $ 13,841.09

Thus, the deduction for AGI is $6,920.55 ($13,841.09 X 50%), or $6,921 (rounded).

(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.

Part 2: Tax Planning

Possible tax planning alternatives available to Wade and Jane Lawrence include: • Consider employing the children part-time in Wade’s business in order to shift some

income to lower tax-bracket taxpayers. Chapter 3 • If the children work part-time and have sufficient earned income, Wade and Jane can

make tax-deductible IRA contributions to accounts maintained separately for each child. If this were to occur, the children would likely pay very little income tax, and be able to get an early start on retirement planning.

• Consider retirement planning for Wade, in particular. Substantial before-tax

contributions can be made to a qualified retirement plan. • Consider purchasing growth stocks in order to minimize current income and

maximize the potential for future appreciation. Wade and Jane can then control the timing of income recognition when most of the income generated by their stock portfolio would be recognized only upon sale of the securities. Chapters 2 and 13

Tax Credits 11-19

• To the extent possible, time the payment of itemized deductions in order to minimize taxes paid and maximize after-tax wealth (e.g., make 2 years of charitable contributions in one year, provided the total would be tax deductible). Chapter 9

• Consider purchasing tax-exempt bonds. Given Wade and Jane’s current income

level and tax bracket, the after-tax return on municipal bonds might be quite attractive. Chapter 4

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 Deductions from AGI: Itemized deductions (Note 4) (9,868) Personal exemption (3,000) Taxable income $59,466 Income tax (Tax Table) $12,404 Self-employment tax (Note 3) 431 Total tax $12,835 Taxes withheld (12,500) Estimated taxes (1,000) Net tax payable (or refund due) for 2002 ($ 665)

See the tax return solution on page 11-21 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 2002 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 $84,900 Less: FICA wages (63,000) Net ceiling $21,900 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%.

(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

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Tax Credits 11-29

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Tax Credits 11-31

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