Tax Credits and the Alternative Minimum Tax - Module 5 of 5

Module 5: Tax Credits and the Alternative Minimum Tax

Tax credits are expenses that reduce the income tax a taxpayer pays on a dollar-for-dollar basis. If the credits are greater than the income tax owed, the taxpayer may receive a “refund” greater than the total amount of tax withheld, resulting in negative income tax. Each type of tax credit is listed in the Internal Revenue Code.  Tax credits are deducted from the income tax after the tax is calculated.

There are currently more than sixty taxpayer credits that can be used by individuals, partnerships, limited liability companies, S Corporations, C Corporations, estates and trusts to reduce federal income tax liability on a dollar-for-dollar basis.  This module provides an overview of the most commonly used tax credits.

First, though, we must discuss the important difference between a refundable tax credit and a nonrefundable tax credit.  Both reduce tax liability dollar-for-dollar. However, a refundable tax credit can continue to reduce tax liability below zero (potentially resulting in a negative income tax), while a nonrefundable credit cannot.[1] For example, if a taxpayer has an income tax liability of $1,500 before any credits are applied and is entitled to a $2,000 refundable tax credit, then the entire credit can be applied, and tax liability will be negative $500. This means the taxpayer receives a $500 refund beyond what she paid in withheld income taxes.  However, if she is entitled to a $2,000 nonrefundable credit, the nonrefundable credit will eliminate the $1,500 federal income tax liability, but the remaining $500 cannot be applied. The federal income tax due will be zero and the taxpayer can get a refund up to the amount that was withheld for her, but she does not benefit from a negative income tax.

Tax Credits for Children and Dependents

            Prior to the Tax Cuts and Jobs Act, each taxpayer could claim a personal exemption[2] of $4,050.  In addition, the taxpayer was entitled to a dependent exemption[3] of $4,050 for each dependent child and relative.  A dependent child[4] is a member of the taxpayer’s family under the age of 19,[5] living with the taxpayer, who did not provide more than one-half of her own financial support, or a full-time student under the age of 24 who was attending college at least 5 months of the year.[6]   A dependent relative[7] is a person with an income less than the exemption amount of $4,050 who is related to the taxpayer, and for whom the taxpayer provided one-half of the dependent relative’s support.

            The Tax Cuts and Jobs Act eliminated the personal and dependent exemptions. However, they were replaced by an increased child tax credit. Under the Act, taxpayers who have children who are under age seventeen on December 31 of the applicable tax year and who derive a majority of their financial support from the taxpayer are eligible for a $2,000 tax credit, per child. The tax is refundable up to $1,400 for each qualifying child.[8]  To be eligible, the child must have a Social Security Number.[9] 

This tax credit is income-restricted based on the amount the taxpayer’s modified adjusted gross income. The credit is reduced by $50 for every $1,000 the taxpayer’s modified gross income exceeds the threshold amount.[10] The threshold amount for single taxpayers, heads of households, and married taxpayers filing separately is $200,000 and 400,000 for married couples filing jointly. Thus, the credit disappears when the modified gross income exceeds $240,000, or $440,00 for married couples filing jointly.[11]

            Similarly, the Code allows certain expenses for dependent care services that are necessary for gainful employment as a nonrefundable tax credit.  This allows a gainfully employed taxpayer to deduct a percentage of expenses incurred to take care of dependents.[12]  To qualify for this credit, the taxpayer must provide more than half the financial support for the dependent, who must be under age 13 and claimed by the taxpayer as a dependent,[13]  a person of any age (such as a spouse) who shares the same principal residence as the taxpayer and is mentally or physically incapable of caring for herself[14] or dependent children of divorced parents.[15] 

Deductible expenses include household expenses and expenses for care of the qualifying individual. The credit is 35% of employment-related expenses, with a 1% reduction in that percentage for each $2,000 the taxpayer’s adjusted gross income exceeds $15,000, with the lowest percentage being 20%.  The maximum credit is $3,000 for one qualifying dependent or $6,000 for two or more qualifying dependents.[16]

For example, if Taxpayer A has an adjusted gross income of $50,000 – which is an excess of $35,000 over the $15,000 threshold amount – then the taxpayer’s allowed percentage is reduced from 35% to 20%.  Therefore, if the taxpayer pays $4,000 in childcare expenses for one child, she can claim a child-care credit of 20% of those $3,000 expenses - a $600 credit.

            The Tax Cuts and Jobs Act adds a nonrefundable tax credit for other dependents.[17]   Those who qualify as dependents are the taxpayer’s children, parents, step-parents, siblings and step-siblings, provided they rely on the taxpayer for more than one-half of their support.[18]  The maximum allowable tax credit is $500 for each dependent.[19]

            Some expenses involved in completing an adoption are deductible as nonrefundable tax credits.[20]  Taxpayers can deduct qualified adoption expenses that include reasonable and necessary adoption fees, court costs, attorney fees and other expenses related to adopting  a child either under age 18 or physically or mentally unable to care for themselves. To qualify, these expenses cannot violate state or federal law, cannot involve a surrogate parenting plan and cannot involve adoption of a spouse’s child.  As of 2019, the maximum federal adoption tax credit is about $14,000.  Regardless of a taxpayer’s filing status, the adoption credit begins phasing out when modified adjusted gross income exceeds $207,140 and disappears when it exceeds $247,140.[21]

Earned Income Tax Credit

            The earned income tax credit[22] is a refundable credit available for low-income taxpayers.  The credit is based on the taxpayer’s family size. The credit is significant and often results in low-income taxpayers getting the benefit of a negative federal income tax.

            The qualify for the credit, the taxpayer must have some “earned” income (such as from a job or the taxpayer’s own business), must receive less than $3,600 in interest,[23] dividend and similar income (this is to avoid giving the credit to those who have independent wealth), must not be married-filing-separately, must be residents of the United States and meet certain other conditions.

For 2019, for families with no qualifying children, the credit is $529.  For families with one qualifying child, the credit is $3,526.  For families with two qualifying children, the credit is $ 5,828.  For families with three or more qualifying children, the credit is $6,557.  A qualifying child must be less than 19 years old on December 31 of the tax year, must reside with the taxpayer and must not have provided more than half of her own support.  The taxpayer claiming the credit must live in the U. S. for more than half the tax year, must be over age 25 and under age 65 and must not be a dependent of another taxpayer.[24] 

This credit is income restricted. As of 2019, for single taxpayers and heads of household, the income limits are $15,570 for no children, $41,094 for one qualifying child, $46,703 for two qualifying children and $50,162 for three or more qualifying children. For married taxpayers filing jointly, the income limits are $21,370 for no children, $46,884 for one qualifying child, $52,493 for two qualifying children and $55,952 for three or more qualifying children.

Education Credits

            The “American opportunity tax credit” [25] is available for taxpayers who pay college tuition for a student who is pursuing a degree, certificate or other credential. This student must be enrolled at least half-time – usually at least six credit hours – for one or more academic periods during the tax year and has not completed four years of postsecondary education.  The qualified student must be the taxpayer or the taxpayer’s spouse or dependent. The tax credit is only available for the first four years a student is enrolled in a four-year program.  If the student takes more than four years to complete a program, the credit is not available after the first four years.  

            The “American opportunity tax credit” is 100% of qualified tuition and related expenses paid for the student during the tax year that do not exceed $2,000 plus 25% of expenses that exceed $2,000 up to $4,000.  Thus, the maximum credit is $2,500 per year. Up to 40% of the credit is refundable which, again, means that up to 40% is available even if it pushes the taxpayer into negative income tax territory.

            The credit has income limitations, as it is fully available to the taxpayer paying the education expenses only if the taxpayer’s modified adjusted gross income does not exceed $160,000 for married taxpayers filing jointly or $80,000 for other taxpayers. Above that income level, the credit phases out, and disappears completely when the modified adjusted gross income exceeds $180,000 for married taxpayers and $90,000 for other taxpayers. [26]

Additionally, a “lifetime learning credit”[27] is also available and is less restrictive than the American opportunity tax credit. Students do not need to be pursuing a degree, certificate or other credential, do not need to be enrolled on a half-time basis and do not need to be in the first four years of a postsecondary education. Taking courses to improve job skills qualifies for the lifetime learning credit. The credit per taxpayer is 20% of qualified tuition and related expenses paid by the taxpayer, up to $10,000 (total, for a lifetime). This credit also has income limitations, however. As of 2019, taxpayers filing joint returns need to have a modified adjusted gross income of $114,000 or less to claim the full credit, and other taxpayers need to have a modified adjusted gross income of $57,000 or less. The credit phases out above that income and disappears when modified adjusted gross income exceeds $134,000 for married taxpayers and $67,000 for other taxpayers.[28]

Retirement Savings Contribution Credit

A “retirement savings contribution credit,”[29] also known as the “saver’s credit,” is a nonrefundable credit available to encourage taxpayers with modest incomes to save for retirement.  This credit is in addition to the income tax deduction provided for contributions to traditional IRAs[30] and other qualifying retirement and pension plans.[31]  The retirement savings contribution credit is worth 10%, 20% or 50% of an annual retirement savings contribution, based on the taxpayer’s adjusted gross income. The higher the income, the smaller the credit percentage. To receive a credit worth 50% of the contribution, the taxpayer’s adjusted gross income must not exceed $38,500 for married taxpayers filing jointly, $28,875 for heads of households or $19,250 for all other taxpayers. To receive a credit worth 20% of the contribution, the adjusted gross income must not exceed $41,500 for married taxpayers filing jointly, $31,125 for heads of households or $20,750 for all other taxpayers. To receive a credit worth 10% of the contribution, the adjusted gross income must not exceed $64,000 for married taxpayers filing jointly, $48,000 for heads of households or $32,000 for all other taxpayers. Above those incomes, the taxpayer is not eligible for the credit.[32]

Miscellaneous Policy-Driven Tax Credits

            Federal tax law also applies certain tax credits specifically to encourage certain behaviors. Some of these include…

The purchase of plug-in electric vehicles qualifies for a tax credit based on battery life.  The credit is $2,500 for a vehicle with a battery that has a minimum capacity of five kilowatt hours.  The credit increases by $417 for each kilowatt hour over the minimum capacity. The maximum increase is $5,000, for a maximum total credit of $7,500.[33]

            The federal solar tax credit allows a credit of up to 30% of the cost of installing solar energy systems for homes or businesses.[34] The credit was established in 2005 and has been renewed by Congress several times since. As of 2019, the credit is scheduled to reduce and phase out for residential installations and drop to 10% for commercial installations by 2022, but it is possible that it will be renewed before then. Taxpayers considering installing solar energy systems should keep up-to-date with developments in this area.

            There are also other tax credits potentially available (especially in commercial settings) for the installation of other renewable energy systems.[35] There are also some available tax credits to subsidize the purchase of health insurance under the Affordable Care Act.[36]

 Alternative Minimum Tax

The alternative minimum tax is the opposite of a tax credit or deduction.[37] The AMT is designed to ensure that high-income taxpayers pay at least a minimum percentage of their income in federal income tax. Therefore, it limits the amount by which most deductions can be used to limit the income tax for high-income taxpayers. The Tax Cuts and Jobs Act of 2017 raised the income limits for exemption from the AMT dramatically and eliminated it for corporations, decreasing the number of taxpayers affected by the AMT by more than 95%.[38] Like most of the Act, it is currently scheduled to sunset in 2025, but for now, we’ll focus on the AMT rules as they are under the Act.

The AMT forces people making more than the exemption amount to calculate their income taxes twice: once under the normal rules and separately under lower tax rates but with fewer allowable exemptions. The taxpayer must pay the greater of the two calculated amounts.

An analysis of the AMT must begin with the exemption amount. There is no AMT on any amounts made under the exemption amount, so only income above the amounts needs to be considered for the AMT. As of 2019, the exemption amount is $70,300 for single taxpayers and $109,400 for married taxpayers filing jointly. (For the sake of simplicity, we’ll focus only on these two categories.) Income above the threshold is taxed at 25% up to $191,100 of additional income. Income above that is taxed at 28% under the AMT.

For our examples, we’ll assume a married couple filing jointly:

If our couple earns $100,000, the AMT is irrelevant since they earn less than the exemption amount.

If our couple earns $200,000, $109,400 is exempt and the remaining $91,600 is taxed at 25% for an AMT of $22,900. Because this is only an effective tax rate of about 11%, the taxpayer’s normal tax rate is likely to be higher. As such, the AMT is probably irrelevant for this couple.

If our couple earns $400,000, $109,400 is exempt, the next $191,100 is taxed at 25% (or $47,775). The remaining $117,300 is taxed at 28% ($32,844), for a total alternative minimum tax of $80,619 – an effective federal income tax rate of about 20%. Depending on the taxpayer’s deductions under the regular tax rules, this couple may or may not be affected by the AMT.  

The exemption amount phases out for incomes over $500,000 ($1,000,000 for married couples filing jointly). So, the AMT can and does still have significant impacts on very high-income taxpayers.[39]

The AMT is calculated in essentially the same manner as regular income tax. While the rates are lower (25% and 28%, as opposed to regular income tax rates, which go as high as 37%), the allowable deductions are greatly reduced. For example, state and local taxes, investment and tax preparation expenses, unreimbursed employee business expenses and the standard deduction itself are disallowed in AMT calculations. However, some deductions, such as qualifying medical expenses, charitable donations, home mortgage interest and qualifying casualty losses are deductible against the AMT as well as under regular tax rules.[40] The IRS provides Form 6251 to allow taxpayers to calculate their alternative minimum taxes and then compare them to their regular taxes. [41]

Conclusion

            Thank you for participating in LawShelf’s video-course on the basics of federal income taxation. We hope you now understand the basics of how federal income taxes are assessed and how income, deductions and credits work in the federal income tax system. Best of luck and please let us know if you have any questions or feedback.