SPECIAL TAX COMPUTATION METHODS, TAX CREDITS, AND PAYMEN OF TAX LEARNING OBJECTIVES After studying this chapter, you should be able to D> Calculate the aterative minimum tax B> Describe what constitutes self-employment income and compute the self-employment tax [> Describe the various business and personal tax credits D> Understand the mechanics of the federal withholding tax system and the requirements for making estimated tax payments14-2 Individuals ¥ Chapter 14 CHAPTER OUTLINE. ‘Alternative Minimum Tax.142 Set-Employment Tax.148 Overview of Tax Creits.14:10 Nonrefundable Personal Tax Credits.14-10 Miscellaneous Credits..14-18 General Business Credits..14-19 Refundable Credis..14-25, Payment of Taxes. 14-26 ‘Tax Planning Consideratons..1431 Compliance and Procedural Considerations..14-33, Chapter 1:2 discussed the basic tax computation for individuals using the tax table and tax rate schedules. This chapter completes the discussion of the tax computation by exam- ining three principal topics: 1. Two special methods of tax computation: the alternative minimum tax and self- employment tax; 2, Various tax credits that are available to reduce tax liability; and 3. Methods for payment of an individual's tax liability, including the pay-as-you-go with- holding rules and estimated tax payment requirements. (AA rerNarive MINIMUM TAX OBJECTIVE 1 Cakculate the alternative ‘minimum tax HISTORICAL NOTE ‘The orginal add-on minimum t ~ enacted in 1968, was 10% of the taxpayer's tax preferences in excess ofa $30,000 statutory exemption EXAMPLE :14-1 > Over the years, Congress has used the income tax law for a variety of purposes other than just raising revenue to fund government operations, such as enacting provisions to pro- mote economic and social goals. As the number of special tax provisions increased, many taxpayers were able to carefully plan their financial affairs to substantially reduce or elim inate their entire income tax liability. As a result, in 1969, Congress passed a new set of rules to ensure that all taxpayers would pay at least a minimum amount of income tax. ‘Thus was born what is known today as the alternative minimum tax (AMT). ‘The original minimum tax was called an add-on minimum tax because it was added to the taxpayer's regular income tax liability. The present AMT system was created in 1978 and is no longer an add-on tax, but is a separate and parallel tax system. Taxpayers are first required to compute their regular income tax liability and then recompute their tax under the AMT system. The AMT system requires taxpayers to adjust their regular tax- able income by a number of adjustments and preferences and then subtract an exemption amount to arrive at the AMT base. The AMT base is then multiplied by special rates to compute the tax, which is called the Tentative Minimum Tax (TMT). Taxpayers are required to pay the greater of (1) the regular income tax, or (2) the TMT. ‘The present AMT system applies to individuals, corporations, estates, and trusts.! Most individual taxpayers are not subject to the AMT because their regular income tax is greater than the TMT. This is primarily because many taxpayers do not have substantial adjustments and preferences and the AMT exemption is liberal in amount (in 2007, $66,250 for married individuals filing a joint return and $44,350 for unmarried individu- als). However, in recent years more and more individuals have been subjected to the AMT. Many of these are not the high-income individuals for which the AMT was intended. The primary reason for this unusual phenomenon is the structure of the AMT system and the fact that the AMT is not indexed for inflation. To date, Congress has not found a cure for the unintended consequences of the AMT, but it applies an annual patch to alleviate it. The 2007 patch was passed in December 2007 in the Tax Increase Prevention Act of 2007. Because we do not expect Congress to enact the 2008 patch until late in 2008, we will use 2007 AMT figures in all examples and problems. Ricardo and Sue are married and file a joint return for the current year with taxable income of $30,000 and tax preferences and adjustments of $12,000. Their alternative minimum taxable income (AMTI is $42,000 ($30,000 + $12,000), but the alternative minimum tax base is zero because ofthe $66,250 exemption. Thus, their tax liability is based on the regular tax computa- tion and no AMT lability is owed. < "The AMT applicable to corporations is discussed in Prentice Halls Federal Taxation: Corporations, Partnerships, Estates, and Trusts text and in the Comprebensive volumeSpecial Tax Computation Methods, Tax Credits, and Payment of Tax ¥ Individuals 14-3 EXAMPLE 14-2 ADDITIONAL COMMENT Some tax advisors recommend ating income into a yea in Which the taxpayer is subject to the AMT because the income will be taxed at 26% or a28% rate rather than a possibly higher rate inalater year EXAMPLE 1:14-3. > KEY POINT For purposes of the alternative ‘minimum tax, no deduction i Allowed for personal exemptions Or the standard deduction, HISTORICAL NOTE, Inthe Revenue Reconciliation Act (of 1993, Congress created a two: tier alternative minimum tax Schedule in order to make the individual income tax system ‘more progressive, ‘Assume the same facts for Ricardo and Sue above except that they have tax preferences and adjustments of $60,000. Their alternative minimum taxable income (AMT) is $90,000 ($30,000 + $60,000). Their regular tax for 2007 based on taxable income of $30,000 would be $3,718, The tentative minimum tax computed under the AMT system (TMT) would be $6,175 ($90,000 minus the AMT exemption of $66,250 yields the AMT base of $23,750. Then $23,750 x AMT tax rate of 26% equals TMT of $6,175). Thus, Ricardo and Sue must pay the TMT of $6,175 in tax since it is greater than their regular tax of $3,718. < AMT COMPUTATION The alternative minimum tax for individuals uses ‘The AMT tax base consists of the following items: two-tiered graduated rate schedule TAXABLE INCOME (computed under the regular income tax system) Plus: AMT tax preference items? Plus: Personal and dependency exemptions The standard deduction if the taxpayer does not itemize Plus or AMT adjustments ALTERNATIVE MINIMUM TAXABLE INCOME (AMTD) Minus: Exemption amount’ ALTERNATIVE MINIMUM TAX BASE, Times: Tax rate (26% of first $175,000; 28% of amounts in excess of $175,000) Minus: Nonrefundable personal credits ‘TENTATIVE MINIMUM TAX Minus: Regular tax after nonrefundable personal credits ALTERNATIVE MINIMUM TAX Phaseout: Basic minus °Exemption amount: Basic AMT exemption: 25% of AMTI in excess of: Married filing jointly and surviving spouse $66,250 $150,000 Unmarried $44,350 $112,500 Married filing separately $33,125 $75,000 Rita, an unmarried taxpayer filing single, has regular taxable income of $185,000 in 2008, a reg- ular tax liability after credits of $46,801, a positive AMT adjustment due to limitations on item- ized deductions of $25,300, and tax preferences of $10,000. Rita's nonrefundable tax cedits were an adoption credit of $1,000 and a child and dependent care credit of $600. Rita's alter- native minimum tax for 2008 is calculated as follows: Taxable income $185,000 Plus: Tax preferences 10,000 Plus: Adjustments related to itemized deductions 25,300 Plus: Personal exemption 3,500 ‘Alternative minimum taxable income (AMT) $223,800 ‘Minus: Exemption amount (16,525) ‘Alternative minimum tax base $207,275 2 Se. $5(H(). authors expect that Congres will not pass the 2008 amounts unt late 2008 3 See. 57 (Se page F144). "The AMT rate on net capital gains ha been redced fom the 26%/28% 4 Sec. $5(d(3). The 2007 AMT patch for exemption amounts was pasted in rates 10 1S%/5% to correspond with the reduction in rates on Net capital the Tax Increase Prevention Act of 2007. Teis only a one-yeat patch. The gins fr egular tx purposes.