Whittenburg Gerald E., Altus-Buller Martha. Income Tax Fundamentals
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SECTION 6.5
FOREIGN TAX CREDIT
U.S. taxpay ers are allowed to claim a foreign tax credit on income earned in a foreign coun-
try and subject to income taxes in that country. The purpose of this credit is to eliminate
double taxation on income earned in a foreign country. Taxpayers may make an annual
election to claim a deduction instead of a credit for the foreign taxes, but most taxpayers
receive a greater tax benefit by claiming the foreign tax credit. Generally, the foreig n tax
credit is equal to the amount of t he taxes paid to foreign governments; however, there is
an ‘‘overall’’ limitation on the amount of the credit, which is calculated as follows:
Net foreign income
U.S. taxable income
U.S. tax liability
EXAMPLE Taxpayer Z has net income of $20,000 from Country K, which imposes
a 15 percent income tax, and $30,000 from Country L, which imposes
a 50 percent income tax. Z has taxable income in 2010 from U.S. sour-
ces of $80,000, and U.S. tax liability before the credit of $35,000. Tax-
payer Z’s foreign tax credit is calculated as follows:
Foreign taxes:
Country K, $20,000 15% $ 3,000
Country L, $30,000 50%
15,000
Total foreign taxes paid
$18,000
Overall limitation:
Net foreign income
U.S. taxable income
U.S. tax liability
$50,000
$20,000 þ $30,000 þ $80,000
$35,000 ¼ $13,462
The foreign tax credit is $13,462, the lesser of the foreign taxes
paid or the overall limitation. N
Unused foreign tax credits may be carried back 1 year and forward 10 years to reduce tax
liability in those years. Different rules apply to income earned in a U.S. possession, and the
rules are presented with Form 1116, Computation of Foreign Tax Credit.
Self-Study Problem 6.4
a. Judy graduates from high school in June 2010. In the fall, she enrolls for
twelve units in Big State University. Big State University considers students
who take twelve or more units full-time students. Judy’s parents pay her
tuition and fees of $1,900, have AGI of $78,000, and claim Judy as a depen-
dent. What is the American Opportunity credit Judy’s parents can claim for
Judy if they file a joint return?
$ ____________
b.In September 2010, Gene pays $5,200 to take a course to improve his job
skills at work. Gene’s AGI is $35,000 for 2010. What is Gene’s lifetime learn-
ing credit for 2010?
$ ____________
Section 6.5
Foreign Tax Credit 6-11
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The foreign tax credit most commonly seen in practice is the credit U.S. taxpayers claim
for foreign taxes withheld on dividends from foreign stock investments. Such investments are
frequently held in mutual funds. The foreign withholding is generally reported to the IRS and
to the taxpayer along with the dividend income from the stock or the mutual fund. The for-
eign tax credit for small amounts of withholding (up to $300 if single and $600 if married)
may be claimed by taxpayers without filing Form 1116, Computation of Foreign Tax Credit.
Foreign taxes withheld may also be deducted as a tax on Schedule A (see Chapter 5), but in
almost all situations the credit will give a better tax benefit than the deduction.
On July 30, 2009, the Wall Street Journal ran a front page headline ‘‘Tax
Evaders Flock to IRS to Confess Their Sins.’’ The U.S. taxpayers in question
were confessing the existence of Swiss bank accounts hiding investments
which were illegally not reported on their tax returns, in hopes that criminal
charges would not be brought against them. The IRS has long sought to crack
down on billions of dollars in taxes lost to tax evaders with hidden offshore
accounts, and is negotiating with several countries to obtain information-
sharing agreements which will give them access to the names and accounts
of numerous high-net-worth tax outlaws.
SECTION 6.6
ADOPTION EXPENSES
Taxpayers are allowed two tax breaks for adoption e xpenses. A tax credit is allowed for
qualified adoption expenses paid by taxpayers, and an exclusion from W-2 income is
allowed for qualified adoption expenses paid by taxpayers’ employers.
Adoption Credit
Individuals are allowed an income tax credit for qualified adoption expenses (defined
below). The total expenses that can be taken as a credit for all tax years with respect to
an adoption of a child are $13,170 (for 2010). The credit is the total amount for each adop-
tion and is not an annual amount (i.e., there is only one $13,170 credit per adopted child).
The amount of the credit allowable for any tax year is reduced for taxpayers with adjusted
gross income (AGI) over $182,520 and is fully phased out when AGI reaches $222,520.
The amount of the credit is reduced (but not below ze ro) by a factor e qual to the excess
Self-Study Problem 6.5
A taxpayer has income of $10,000 from Country A, which imposes a 20 percent
income tax, and $20,000 from Country B, which imposes a 50 percent income
tax. The taxpayer has U.S. taxable income, including income from Country A
and Country B of $90,000, and U.S. tax liability before credits of $20,000.
Calculate the amount of the foreign tax credit.
$ ____________
6-12 Chapter 6
Credits and Special Taxes
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of the taxpayer’s AGI over $182,520 divided by $40,000. In some cases, beyond the scope
of this text, AGI must be modified prior to calculating the adoption credit phase-out. For
additional information on calculating modified adjusted gross income (MAGI), see the IRS
Web site at www.irs.gov.
EXAMPLE Ben and Beverly pay $4,500 of qualified adoption expenses in 2010 to
adopt a qualified child. Their AGI is $185,000 for 2010, which causes
an adoption credit reduction for 2010 of $279 [$4,500 ($185,000
$182,520)/$40,000)]. Thus, Ben and Beverly’s allowable adoption credit
for 2010 is $4,221 ($4,500 $279). N
Domestic Multi-Year Adoptions
In the case of the adoption of an eligible child who is a U.S. citizen or resident of the U.S.
at the time the adoption commenced, the credit for qualified adoption expenses is
allowed for the tax year that follows the year during which the expenses are paid or
incurred, unless the expenses are paid or incurred in the tax year the adoption becomes
final. If the expenses are paid or incurred during the tax year in which the adoption
becomes final, the credit is allowed for that year. For ‘‘special needs’’ adoptions, the
credit is only allowed in the year in which the adoption becomes final. The $13,170 credit
is allowed in special needs adoptions regardless of the amount of qualified adoption
expenses paid.
EXAMPLE In connection with the adoption of an eligib le child who is a U.S. citi-
zen and is not a child with special needs, a taxpayer pays $6,000 of
qualified adoption expenses in 2009 and $7,500 of qualified adoption
expenses in 2010. The adoption is not finalized until 2011. The $6,000
of expenses paid or incurred in 2009 would be allowed in 2010, and
$7,170 of the $7,500 paid or incurred in 2010 would be allowed in
2011. On the other hand, if the adoption were finalized in 2010, then
$13,170 of qualified expenses would be allowed in 2010 (the maxi-
mum credit permitted as of 2010). N
Foreign Multi-Year Adoptions
In the case of the adoption of a child who is not a U.S. citizen or resident of the U.S., the
credit fo r qualified adoption expens es is not available unless t he adoption becomes final.
Qualified adoption expenses paid or incurred before the tax year in which the adoption
becomes final are taken into account for the credit as if the expenses were paid or incurred
in the tax year in which the adoption becomes final. Therefore, the credit for qualified
adoption expenses paid or incurred in the tax year in wh ich the adoption becomes final,
or in any earlier tax year, is allowed in the tax year the adoption becomes final.
EXAMPLE In 2009 and 2010, a taxpayer pays $3,000 and $6,000, respective ly, of
qualified adoption expenses in connection with the adoption of an
eligible child who is not a U.S. citizen or resident of the U.S. In 2011,
the year the adoption becomes final, the taxpayer pays an additional
$3,000 of qualified expenses. The taxpayer may claim a credit of
Section 6.6
Adoption Expenses 6-13
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$12,000 on his or her income tax return for 2011 (the year the adop-
tion becomes final). Note: If a foreign adoption does not become
final, then no credit is allowed. N
The credit is limited to the taxpayer’s tax liability; howev er, any unused credit can be
carried over for up to 5 years. Also, to get the credit, married individuals must file jointly,
and the taxpayer must include (if known) the name, age, and taxpayer identification number
(TIN) of the child on the return.
Employer-Provided Adoption Assistance
An employee may exclude from W-2 earnings amounts paid or expenses incurred by his or
her employer for qualified adoption expenses connected with the adoption of a child by the
employee, if the amounts are furnished un der an adoption assistance progr am. The total
amount excludable per child is limited to $13,170. The excludable amount for any tax
year is phased out for taxpayers with adjusted gross income over $182,520 and is fully elim-
inated when AGI reaches $222,520. The phase -out is calculated in the same manner as the
phase-out for the adoption credit.
Coordination of Adoption Credit and Exclusion
An individual may claim both a credit and an exclusion in connection with the adoption
of an eligible child, but may not claim both a credit and an exclusion for the same
expense.
EXAMPLE In 2010, an unmarried individual pays $14,020 in qualified adoption
expenses to an adoption agency for the final adoption of an eligible
child who is not a child with special needs. In the same year, the indi-
vidual’s employer, under a qualified adoption assistance program,
pays an additional $5,000 for other qualified adoption expenses to an
attorney on behalf of the employee for the adoption of the child.
Assuming the individual is not subject to the phase-out, the individual
may claim a credit of $13,170 and may exclude $5,000 from gross
income, because the credit and the exclusion are not for the same
expenses. The remaining $850 may never be claimed as a credit or
excluded from gross income. N
Qualified Adoption Expenses
Qualified adoption expenses are reasonable and necessary adoption fees, court costs, attor-
ney fees, and other expenses directly related to, and of which the principal purpose is for,
the taxpayer’s legal adoption of an eligible child.
The following quotation is often attributed to Albert Einstein:
‘‘The hardest thing in the world to understand is the income tax.’’
6-14 Chapter 6
Credits and Special Taxes
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SECTION 6.7
ENERGY CREDITS
Three major energy credits are available to ind ividual tax payers to encourage the use of
energy-efficient products. These include the credit for energy-efficient vehicles (hybrid
vehicles a nd a credit for p lug-in electric vehicle s), the $1,500 credit for energy-efficient
home improvements, and the 30 percent credit for solar, wind, and geothermal property.
Energy-Efficient Vehicle Credits
For tax years 2006 through 201 0, taxpayers are allowed a credit for the purchase of new
personal-use or business-use hybrid gas-electric vehicles. The credits allowed for each
model of hybrid car vary based on a formula related to weight class and fuel economy,
and range between $250 and $3,150 per vehicle. The credit phases out for manufacturers
as soon as they have sold 60,000 hybrid vehicles. The Toyota and Lexus hybrid credits
(Toyota owns Lexus) w ere fully phased out with no credits allowed as of October 2007.
Therefore, no credit is allowed for the popular Toyota Prius. Honda hybrid credits
were completely phased out on January 1, 2009. Ford and Mercury hybrids purchased
prior to April 1, 2009, qualified for the full credit available, but credits on these cars
were phased out before being eliminated entirely on April 1, 2010. The IRS Web site
(www.irs.gov) contains detailed information on th e credits available for each hybrid
sold by model year and by date of purchase.
In 2010, taxpayers are allowed a credit for the purchase of plug-in electric drive vehicles
used for either business or personal purposes. The credit, which ranges between $2,500
and $7,500 for light-duty vehicles, varies depending on the weight of the vehicle and the
kilowatt hour of tractio n battery capacity. A 10 percent credit of up to $4,000 is allowed
for the cost of converting any motor vehicle into a qualified plug-in electric drive vehicle.
A 10 percent credit up to a maximum of $2,500 is also allowed for electric drive low-speed
vehicles, motorcycles, and three-wheeled vehicles designed mainly for use on public streets.
Electric carts designed for off-road use on golf courses do not qualify.
$1,500 Credit for Home Energy-Efficient Improvements
This credit is calculated as 30 percent of the cost of qualifying property purchased up to a
maximum credit of $1,500 for 2009 and 2010 combined. Thus, taxpayers may purchase up
to $5,000 of energy-efficient property in 2009 and 2010 in return for a credit which totals
$1,500. The $500 energy-efficient home improvement credit taken under a similar provi-
sion in prior years, with a $500 lifetime maximum, may be disregarded for purposes of the
$1,500 credit.
Self-Study Problem 6.6
Andrew and Amy Anderson finalized the adoption of their daughter Allison in
October 2010. Allison is a U.S. citizen and is not a special needs child. Her
Social Security number is 466-47-3311. In 2010, Andrew and Amy paid $17,000
in qualified adoption expenses. In addition, Am y’s employer paid $4,000
directly to an adoption agency as an employer-provided adoption benefit. The
Anderson’s AGI for 2010 is $185,000 (assume adjusted gross income and modi-
fied adjusted gross income are the same for purposes of this problem). Use
Form 8839 on pages 6-17 and 6-18 to calculate the Andersons’ adoption credit
and the amount of any employee adoption exclusion.
Section 6.7
Energy Credits 6-15
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The improvements must be made to the taxpayer’s principal residence and must meet
specified measures of energy efficiency. Taxpayers must keep the manufacturer’s certifica-
tion of eligibility and the purchase documents as proof that these tests have been met.
Improvements which qualify for the credit include the cost of certified energy-efficient
windows, including skylights and storm windows, insulation, exterior doors, and certain
roofs. Central air conditioners, high-efficiency heat pumps, furnaces, boilers, and water
heaters also qualify.
EXAMPLE In 2009, John spends $2,000 on certified energy-efficient insulation
for his main home and installs certified energy-efficient windows
costing $2,000. In 2010, he spends $3,000 on a new, certified, energy-
efficient natural gas boiler for his main home. For 2009, he may claim
a $1,200 tax credit ($4,000 30%). For 2010, he may only claim an
additional $300 credit for the $3,000 boiler since he will have reached
his lifetime credit limit of $1,500. N
Credits for Residential Energy-Efficient Property (REEP Credit)
In tax year 2010, taxpayers may claim a credit of 30 percent of the amount paid for qualified
solar electric property (property which uses solar power to generate electricity in a home),
qualified solar water-heating property, qualified small wind energy property, and qualified
geothermal heat pump property, which uses ground or ground water as a thermal energy
source to heat or cool a residence. A different but significan t credit is allowed for qualified
fuel cell property to generate electricity for use in a residence.
The REEP credits described in the paragraph above may be claimed for both principal
residences and vacatio n homes. No credit is allowed for installations used to heat swim-
ming pools or hot tubs. The REEP credit is expected to significantly increase the number
of solar and wind energy installations in coming years in addition to assisting the growing
solar and wind energy industries.
EXAMPLE In 2010, Mary buys $30,000 of solar electric property for her second
(vacation) home. The equipment is not used to heat her swimming
pool or hot tub. She may claim a credit of $9,000 ($30,000 30%) for
2010. N
Self-Study Problem 6.7
Calculate the energy credit allowed for the following purchases:
a. Geoffrey purchases a Toyota Prius in May of 2010.
Credit Allowed _________
b.Gwen purchases $2,000 of qualified, energy-efficient insulation and $2,000
of energy-efficient windows for her principal residence in 2010.
Credit Allowed _________
c. Parker purchases $6,000 of qualified, energy-efficient insulation for his
second (vacation) home in 2010.
Credit Allowed _________
d.Betty purchases a solar system to heat her hot tub for $2,000 and a second,
certified, energy-efficient solar system to heat her home for $10,000 in 2010.
Credit Allowed _________
6-16 Chapter 6
Credits and Special Taxes
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Section 6.7
Energy Credits 6-17
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6-18 Chapter 6
Credits and Special Taxes
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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.
SECTION 6.8
THE INDIVIDUAL ALTERNATIVE MINIMUM TAX (AMT)
Please see the ‘‘As We Go To Press’’ page at the beginning of the text and the caveat at the
beginning of the ‘‘AMT Exemption’’ subsection on the next page.
Many individual taxpayers are subject to two parallel tax calculations, the regular tax and
the alternative minimum tax (AMT). The AMT was designed in the 1960s to ensure that
wealthy taxpayers could not take advantage of special tax write-offs (tax pre ferences and
other adjustments) to avoid paying tax. In general, taxpayers must pay the alternative min-
imum tax if their AMT tax liability is larger than their regular tax liability.
The AMT is calculated on Form 6251, using the following formula simplified for pur-
poses of this text:
Regular Taxable Income (before exemptions and standard deduction)
þ
Plus or minus AMT preferences and adjustments
Equals Alternative Minimum Taxable Income (AMTI)
Less AMT exemption (phased out to zero as AMTI increases)
Equals amount subject to AMT
Multiplied by the AMT tax rate(s)
Equals Tentative Minimum Tax
Less Regular Tax
¼
Equals amount of AMT due with tax return if a positive amount
Common AMT Adjustments and Preferences
The terms ‘‘AMT Adjustments’’ and ‘‘AMT Preferences’’ are often used interchangeably,
though they have slightly different meanings. In general, adjustments are timing differen-
ces that arise because of differences in the regular and AMT tax calculations (e.g., depre-
ciation timing differences), while preferences are special prov isions for the regular tax
that are not allowed for the AMT (e.g., state income taxes). Both terms refer to items
which adjust regular taxable income to arrive at income which is subject to alternative
minimum tax. There are over twenty different types of adjustments and preferences
used in the calculation of AMT on Form 6251. Some of the common adjustments and
preferences are as follows:
The standard deduction allowed for regular tax is not allowed for AMT.
Personal and dependency exemptions are not allowed as deductions for AMT.
The deduction for AMT medical expenses must be limited to 10 percent of AGI
rather than 7.5 percent as required by the regular tax.
The deductions for property tax, state income tax, and other taxes allowed
as itemized deductions for regular tax are not allowed for AMT.
Only the deduction for home mortgage interest related to the purchase or improve-
ment of a first or second residence is deductible for AMT, so the interest deduc-
tion on home equity debt of up to $100,000 used for personal purposes such as
automobile purchases is not allowed for AMT.
Miscellaneous deductions are not allowed for AMT.
Because only certain itemized deductions are allowed for AMT, the regular tax item-
ized deduction phase-out for high-income taxpayers is not required for AMT.
Depreciation is generally calculated over a longer life for AMT, sometimes using a
different method.
Net Operating Losses are calculated differently for AMT and often result in an
adjustment when they are present.
Section 6.8
The Individual Alternative Minimum Tax (AMT) 6-19
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State income tax refunds are not considered income for AMT since the state
income tax deduction is not allowed for AMT.
Private activity bond interest is interest from certain municipal bonds not taxed for
regular tax purposes, but taxable for AMT. However, interest on private activity
bonds issued in 2009 and 2010 is not taxed for AMT.
Other less commonly seen AMT differences include such items as the calculations
related to incentive stock options, oil and gas depletion, research and develop-
ment expenses, gains on asset sales such as rental real estate, passive losses,
and the gain exclusion for small business stock and other items .
The actual details of the calculation of several of the AMT tax preferences and adjust-
ments are complex and infrequently seen in practice. For further information, please con-
sult the IRS Web site, a tax service, or an advanced tax textbook.
AMT Exemption
As we go to press in late 2010, the 2010 AMT exemption amounts remain uncertain. We
have assumed that the exemptions will be equal to the amounts allowed for 2009, adjusted
for i nflation, and that other elements of the calculation will stay the same as in 2009.
Please check the Whittenburg Web site to see if the law and the problems as written
have been changed.
In 2010, t he AMT exemption allowance is $71,050 for married taxpayers filing joint
returns, $46,750 for single and head of household taxpayers, and $35,525 for married tax-
payers filing separate returns. The exemption allowance amount is phased out for high-
income taxpayers. The amount of the exemption is reduced 25 cents for each dollar by
which the taxpayer’s alternative minimum taxable income exceeds certain threshold
amounts, which are $150,000 for married taxpayers filing a joint return, $75,000 for mar-
ried taxpayers filing separately, and $112,50 0 for single taxpayers and taxpayers filing as
head of household.
EXAMPLE Abby, a single taxpayer, has AMTI of $122,000 in 2010. Her AMT
exemption is $44,375, which is calculated as $46,750 [25%
($122,000 $112,500)]. N
AMT Tax Rates
For 2010, the alternative minimum tax rates for calculating the tentative AMT are 26 per-
cent of the first $175,000 ($87,500 for married taxpayers filing separately), plus 28 percent
on amounts above $175,000. These rates are applied to the taxpayer’s alternative minimum
tax base from the formula above. The alternative minimum tax rate for capital gains and
dividends is limited to the rate paid for regular tax purposes (e.g., capital gain or qualified
dividends taxed at 15 percent for regular tax purposes will also be taxed at a 15 percent
alternative minimum tax rate).
EXAMPLE Teddy has an alternative minimum taxable income after the exemp-
tion deduction of $270,000, none of which is from capital gains. His
tentative AMT tax is $72,100, which is calculated as (26% $175,000) þ
(28% [$270,000 $175,000]). N
The AMT has become a controversial tax in recent years. Many middle class taxpayers
now pay alternative minimum tax because the reduction in regular tax rates in recent years
has not been matched by a reduction in AMT tax rates and the AMT exemptions have not
been indexed for inflation. Certain items not allowed as deductions for alternative
6-20 Chapter 6
Credits and Special Taxes
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