💰Federal Income Tax Accounting Unit 9 – Tax Credits

What Are Tax Credits?

• Tax credits are dollar-for-dollar reductions in the amount of income tax owed
• Directly reduce tax liability after calculating taxable income and applying tax rates
• Differ from tax deductions which reduce taxable income before calculating tax liability
• Can be refundable (allowing for a refund if the credit exceeds tax liability) or non-refundable (can only reduce tax liability to zero)
• Designed to encourage certain behaviors or provide financial relief to specific groups of taxpayers
• May have income thresholds or phase-out ranges that limit eligibility based on the taxpayer's income level
• Can be claimed by individuals, businesses, or other entities depending on the specific credit

Types of Tax Credits

• Earned Income Tax Credit (EITC) for low to moderate-income working individuals and families
  • Refundable credit based on income and number of children
  • Encourages work and reduces poverty
• Child Tax Credit for taxpayers with dependent children under age 17
  • Partially refundable credit that helps offset the cost of raising children
• American Opportunity Tax Credit (AOTC) and Lifetime Learning Credit (LLC) for higher education expenses
  • AOTC is partially refundable and covers first four years of post-secondary education
  • LLC is non-refundable and available for any level of post-secondary education
• Retirement Savings Contributions Credit (Saver's Credit) for low to moderate-income taxpayers who contribute to retirement plans
• Adoption Credit for expenses related to adopting a child
• Residential Energy Efficient Property Credit for installing solar, wind, geothermal, or fuel cell property in a home
• Foreign Tax Credit for taxpayers who paid income taxes to a foreign government

Eligibility Requirements

• Each tax credit has its own set of eligibility criteria that taxpayers must meet to claim the credit
• Common requirements include income thresholds, filing status, and specific expenses incurred
• Some credits are only available to taxpayers with earned income (wages, salaries, tips, and self-employment income)
• Credits may have age restrictions for the taxpayer or their dependents
• Certain credits require the taxpayer to provide documentation or proof of expenses
  • Example: Form 1098-T for education credits or receipts for child care expenses
• Eligibility for refundable credits may be limited by the taxpayer's investment income
• Taxpayers must have a valid Social Security Number (SSN) to claim most credits
  • Some credits allow taxpayers with Individual Taxpayer Identification Numbers (ITINs) to claim the credit

Calculating Tax Credits

• Each tax credit has its own formula for calculating the credit amount
• Some credits have a fixed amount per taxpayer or dependent, while others are based on a percentage of expenses incurred
• Refundable credits can result in a negative tax liability, allowing the taxpayer to receive a refund
• Non-refundable credits can only reduce tax liability to zero
• Some credits have income phase-out ranges where the credit amount is gradually reduced as income increases
  • Phase-out calculations involve determining the applicable percentage of the credit based on income level
• Certain credits have maximum limits on the amount that can be claimed per taxpayer or tax return
• Tax software and online calculators can help taxpayers determine their eligibility and credit amounts

Claiming Tax Credits on Tax Returns

• Taxpayers claim tax credits by completing the appropriate forms and schedules and attaching them to their tax return
  • Example: Schedule 3 for the Foreign Tax Credit or Form 8863 for education credits
• Some credits require additional forms or documentation to be filed with the return
• Taxpayers must provide accurate information and calculations to avoid delays or rejections in processing their return
• Credits are applied after calculating taxable income and tax liability but before subtracting tax payments and withholdings
• Refundable credits can result in a tax refund even if the taxpayer had no income tax withheld or paid estimated taxes
• Non-refundable credits can only reduce tax liability and any excess credit is not refundable or carried forward to future years

Impact on Tax Liability

• Tax credits directly reduce the amount of tax owed, dollar-for-dollar
• Refundable credits can result in a negative tax liability and a refund to the taxpayer
  • Example: If a taxpayer has a $1,000 tax liability and a$1,500 refundable credit, they will receive a $500 refund
• Non-refundable credits can reduce tax liability to zero but cannot generate a refund
  • Example: If a taxpayer has a $1,000 tax liability and a$1,500 non-refundable credit, their tax liability is reduced to zero, but they do not receive the excess $500 as a refund
• Credits can significantly lower a taxpayer's effective tax rate (the percentage of their income paid in taxes)
• The impact of credits on tax liability depends on the taxpayer's income, filing status, and eligibility for specific credits
• Some credits, such as the Earned Income Tax Credit, are designed to provide financial support to low-income taxpayers and can greatly reduce or eliminate their tax liability

Common Mistakes and Pitfalls

• Claiming credits without meeting all eligibility requirements
  • Taxpayers should carefully review the criteria for each credit and ensure they qualify before claiming it on their return
• Miscalculating credit amounts or phase-outs
  • Taxpayers should use the correct formulas and income thresholds when determining their credit amounts
• Failing to attach required forms or documentation
  • Some credits require additional paperwork to be filed with the return, and omitting these documents can delay processing or result in the credit being denied
• Claiming the same expenses for multiple credits
  • Taxpayers cannot double-dip by using the same expenses to claim multiple credits (such as claiming both the Child Tax Credit and Child and Dependent Care Credit for the same child)
• Not updating information with the IRS
  • Taxpayers should ensure their name, address, and bank account information are current to avoid delays in receiving refunds or correspondence
• Overlooking new or updated credits
  • Tax laws change frequently, and taxpayers should stay informed about new credits or changes to existing ones that may affect their eligibility or credit amounts

Recent Changes and Updates

• The American Rescue Plan Act (ARPA) of 2021 made several temporary changes to tax credits for the 2021 tax year
  • Expanded the Child Tax Credit by increasing the credit amount, raising the age limit to 17, and making it fully refundable
  • Increased the Child and Dependent Care Credit and made it refundable
  • Nearly tripled the maximum Earned Income Tax Credit for workers without children
• The Consolidated Appropriations Act (CAA) of 2021 extended several expiring tax provisions and made some credits permanent
  • Made the Lifetime Learning Credit and American Opportunity Tax Credit permanent
  • Extended the residential energy efficient property credit through 2023
• The Inflation Reduction Act (IRA) of 2022 extended and modified several energy-related tax credits
  • Extended the residential energy efficient property credit through 2034 and increased the credit amount
  • Created a new clean vehicle credit for electric and fuel cell vehicles with specific requirements for battery components and assembly
• Taxpayers should consult with a tax professional or use reliable resources to stay updated on the latest changes to tax credits and how they may impact their tax situation