CHAPTER 13



CHAPTER 12

TAX CREDITS

SOLUTIONS TO PROBLEM MATERIALS

| | | | |Status: | | Q/P |

|Question/ | | | |Present | | in Prior |

|Problem | |Topic | |Edition | |Edition |

| | | | | | |

|1 | |Tax credit versus deduction | |Unchanged |1 |

|2 | |Refundable versus nonrefundable credits | |Unchanged |2 |

|3 | |Components of general business credit | |Unchanged |4 |

|4 | |Calculation of and limitation on general business credit | |New | |

|5 | |Issue ID | |Unchanged |6 |

|6 | |Recapture of tax credit for rehabilitation expenditures | |New | |

|7 | |Work opportunity tax credit | |Unchanged |7 |

|8 | |Welfare-to-work credit | |Unchanged |8 |

|9 | |Research expenditures tax credit and deduction | |Unchanged |9 |

|10 | |Disabled access credit | |Unchanged |10 |

|11 | |Earned income credit | |Unchanged |11 |

|12 | |Earned income credit | |New | |

|13 | |Foreign tax credit: qualifying taxes | |Unchanged |13 |

|14 | |Foreign tax credit: overall limitation | |New | |

|15 | |Issue ID | |Unchanged |15 |

|16 | |Adoption expenses credit: calculation | |Unchanged |16 |

|17 | |Child tax credit versus credit for child and dependent care expenses | |Unchanged |17 |

|18 | |Credit for child and dependent care expenses | |New | |

|19 | |Credit for child and dependent care expenses versus reimbursement plan | |Modified |19 |

|20 | |Issue ID | |New | |

| | | | | | |

| | | | | | |

|21 | |Incentive effects of credit for small employer pension plan startup costs | |Unchanged |21 |

| | |and credit for certain retirement plan contributions | | | |

|22 | |Rationale for various credits | |Unchanged |22 |

|* 23 | |Limitation on general business credit for individuals |Unchanged |23 |

|* 24 | |Use of general business credit carryovers | |Modified |24 |

|25 | |Certified historic structure tax credit for rehabilitation expenditures | |Unchanged |25 |

|* 26 | |Work opportunity tax credit | |Unchanged |26 |

|* 27 | |Welfare-to-work credit | |Modified |27 |

|* 28 | |Incremental research activities credit | |Modified |28 |

|29 | |Disabled access credit | |Modified |29 |

|30 | |Earned income credit | |Unchanged |30 |

|* 31 | |Earned income credit | |New | |

|* 32 | |Earned income credit | |Modified |32 |

|* 33 | |Tax credit for elderly or disabled taxpayers | |New | |

|* 34 | |Foreign tax credit | |Unchanged |34 |

|* 35 | |Foreign tax credit | |New | |

|36 | |Adoption expenses credit | |Unchanged |36 |

|37 | |Child tax credit | |Unchanged |37 |

|38 | |Credit for child and dependent care expenses | |Unchanged |38 |

|39 | |Credit for child and dependent care expenses: payments to relatives | |New | |

|40 | |Education tax credits | |Unchanged |40 |

|41 | |Credit for certain retirement plan contributions | |Unchanged |41 |

|* 42 | |Cumulative | |New | |

|* 43 | |Cumulative | |Modified |43 |

|Research | | | | | | |

|Problem | | | | | | |

| | | | | | |

|1 | |Tax credit for rehabilitation expenditures | |New | |

|2 | |Research activities credit | |Unchanged | |

|3 | |Internet activity | |Unchanged | |

*The solution to this problem is available on a transparency master.

CHECK FIGURES

23. $5,000.

24. Credit allowed $80,000; credit carried forward $10,000.

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. $3,000.

28.b. Taking the reduced deduction and the full credit provides the greater benefit.

29. Credit available of $4,125.

30.a. Not eligible.

30.b. Eligible.

30.c. Not eligible.

30.d. Eligible.

31. $3,150.

32.a. $863.

32.b. Joyce should probably accept the job offer (cash flow of $29,340 for old job; $32,727 for new job).

33. Credit available of $488 prior to the limitation.

34.a. Foreign tax credit $7,998; income tax payable $10,477.

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

35. $45,000.

36.a. $10,390.

36.b. $5,418.

37.a. $2,000.

37.b. $1,550.

38. $1,200.

39. $1,400.

40. $1,225.

41.a. Credit available $800.

41.b. May not claim credit.

42. Refund due $177.

43. Refund due $113.

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. 12-4 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.

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

3. 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 12-1

4. 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.

pp. 12-5 and 12-6

5. 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. pp. 12-7 and 12-8

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. p. 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.

p. 12-10

9. In general, qualified research and experimentation expenditures not only are eligible for the 20% 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% of the credit.

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

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. 12-11 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. pp. 12-13 and 12-14

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. 12-17

12. In general, the earned income credit is available to individuals whose income is below certain thresholds. For example, in 2004 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 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. 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. p. 12-20

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. pp. 12-19, 12-20, 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 2004, up to $10,390 ($10,160 in 2003) 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 $155,860 (in 2004 and it is totally eliminated when the AGI reaches $195,860. In 2003, the phaseout began when AGI exceeded $152,390.

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.

pp. 12-20 and 12-21

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 in 2003 and 2004. For 2003, an advance payment of $400 per child was mailed to qualified taxpayers during the year. Therefore, an additional $600 per child may be claimed on the 2003 tax return. 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%, 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 12-24

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 $87,900 in 2004.

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

pp. 12-22 to 12-24

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. 12-24 and 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 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. 12-25 and 12-28

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. 12-13

c. Research activities credit. The research activities credit is intended to encourage research and experimentation in the United States. p. 12-11

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. 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

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. p. 12-9

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. 12-6 and Example 7

24. 2004 general business credit $45,000

Total credit allowed (based on tax liability) $80,000

Less: Utilization of carryovers on FIFO basis

2000 (5,000)

2001 (15,000)

2002 (5,000)

2003 (20,000)

Remaining credit allowed $35,000

Applied against

2004 general business credit (35,000)

2004 unused amount carried forward to 2005 $10,000

Therefore, the sources of the $80,000 general business credit allowed in 2004 are the carryovers of $45,000 from the four previous years and $35,000 of the $45,000 general business credit generated in 2004.

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. 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 improvements) – $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, 2005

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).

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. 12-7 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

Note: Although the work opportunity tax credit expires at the end of 2003, there is good reason to believe that Congress will extend it. When such an extension occurs, it probably will be made retroactive in application.

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

pp. 12-9, 12-10, 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. However, there is good reason to believe Congress will extend it. When such an extension occurs, it probably will be made retroactive in application.

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)].

pp. 12-10, 12-11, 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. 12-11, 12-12, 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

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. 12-11, 12-12, and Example 16

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

5191 Natorp Boulevard

Mason, OH 45040

September 30, 2004

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

p. 12-13

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 $11,490 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 $30,338 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. 12-15 to 12-17 and Table 12-2

31. Gross income (earnings) $19,500

Less: Deduction for AGI (traditional IRA) (500)

Adjusted gross income $19,000

Maximum credit available for 2004 for two or more children $4,300

($10,750 X 40%)

Less: Credit phase-out

Earned income* $19,500

Threshold (14,040)

Excess $ 5,460

Phase-out rate X 21.06% (1,150)

Available earned income credit for Vern $3,150

*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 2004 for two children $4,300

($10,750 X 40%)

Less: Credit phase-out

Earned income $30,000

Threshold (14,040)

Excess $15,960

Phase-out rate X 21.06% (3,361)

Available earned income credit for Joyce $ 939

Table 12-2 and Example 22

b. Keeps Takes

old job   new job  

Tax calculation:

Salary $30,000 $35,000

Less: Standard deduction* (7,150) (7,150)

Personal and dependency exemptions

($3,100 X 3) (9,300) (9,300)

Taxable income $13,550 $18,550

Income tax (based on tax rate schedule)* $ 1,523 $ 2,273

Less: Earned income credit (939) (-0-)

Net tax due $ 584 $ 2,273

After-tax cash-flow:

Salary $30,000 $35,000

Less: Net tax due (584) (2,273)

After-tax cash-flow $29,416 $32,727

* 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 $1,689 ($2,273 – $584) if she takes the new job, her net cash-flow will increase by $3,311 ($32,727 – $29,416). 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

pp. 12-18, 12-19, Table 12-3, and Example 24

34. a. $50,000 (Foreign source TI) X $18,475** (U.S. tax) $ 7,998

$115,500 (Worldwide TI)*

Total foreign taxes paid $26,000

Foreign tax credit: [lesser of $7,998 (foreign tax credit limitation)

or $26,000 (foreign taxes paid)] $ 7,998

*$100,000 + $15,500 [5 X $3,100 (personal and dependency exemptions not allowed)].

**Tax on $100,000 = $18,475 per Schedule Y-1 for 2004.

Kim’s net U.S. income tax payable = $18,475 – $7,998 (foreign tax credit) = $10,477.

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 $18,002 carryback or carryforward is created [$26,000 (foreign taxes paid) – $7,998 (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 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. 12-19, 12-20, 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. 12-20 and Example 25

36. a. Ann and Bill must claim the adoption expenses credit in 2004 ($4,000 + $6,390, limited to $10,390), 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 2004 for $10,390. The amount of expenses paid in excess of $10,390 is a nondeductible personal expense. Further, because their modified AGI is less than $155,860, the amount of the credit otherwise available is not reduced.

b. $5,418 = $10,390 – {$10,390 X [($175,000 – $155,860) ÷ $40,000]}.

pp. 12-20, 12-21, 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) for 2004.

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. 12-22 and Example 28

38. For two or more children, the maximum expense allowed 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. 12-22 and 12-23

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 long as the mother does not qualify as Ralph’s and Jill’s dependent.

pp. 12-22, 12-23, and Example 29

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 $2,275 [($98,000 AGI – $85,000 threshold)/$20,000 phase-out range X $3,500], resulting in a $1,225 ($3,500 – $2,275) education credit for 2004.

pp. 12-24, 12-25, 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. 12-28

CUMULATIVE PROBLEMS

42. Dan’s salary $ 8,000

Pat’s salary 14,000

Interest income 50

Unemployment compensation 5,500

Gross income (Note 1) $27,550

Less: Deductions for AGI (-0-)

Adjusted gross income $27,550

Less: Standard deduction (Note 2) (9,700)

Personal and dependency exemptions ($3,100 X 4)

(Dan, Pat, Sam, Fred) (12,400)

Taxable income $ 5,450

Income tax determination:

Tax on $5,450 $ 545

Less: Income tax withheld $ 400

Credit for child and dependent care

expenses [23% X $6,000 (Note 3)] 1,680 (2,080)

Net tax payable (or refund due) ($ 1,535)

Notes

(1) The dividends of $350 are includible in gross income in 2005, since the check was received in 2005.

(2) Unreimbursed travel expenses other than meals $1,050

Meals ($200 X 50%) 100

Total miscellaneous itemized deductions $1,150

Less: 2% of $27,550 (AGI) (551)

$ 599

Other itemized deductions 6,600

Total itemized deductions $7,199

The standard deduction of $9,700 is used in the income tax computation because it exceeds the itemized deductions.

(3) Expenditures of up to $6,000 qualify for the credit, since care is being provided for both Sam and Fred. Payments to relatives (i.e., Nora) qualify if the relative is not a dependent or a child of the taxpayer under age 19. The applicable percentage is 28% since AGI is over $27,000 but not over $29,000. The credit of $1,680 ($6,000 X 28%) is allowed in full because it does not exceed the tax liability.

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 (3,050)

Taxable income $59,416

Income tax (Note 5) $11,456

Self-employment tax (Note 3) 431

Total tax $11,887

Taxes withheld (11,000)

Estimated taxes (1,000)

Net tax payable (or refund due) for 2003 ($ 113)

See the tax return solution 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 2003 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 $87,000

Less: FICA wages (63,000)

Net ceiling $24,000

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

(5) Tax on taxable income of $59,416

Tax on dividend income ($2,100 X 15%) $ 315

Tax from Tax Table on remaining taxable income of $57,316

($59,416 – $2,100) 11,141

Total income tax $11,456

The answers to the Research Problems are incorporated into the 2005 Comprehensive Volume of the Instructor’s Guide with Lecture Notes to Accompany WEST FEDERAL TAXATION: COMPREHENSIVE VOLUME.

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