Tax Fundamentals Dependents Credits

Theme 1: Filing Status & Dependents

This section covers Questions: 10, 11, 16, 20, 21, 27, 48, 60

Filing Status (Q.10, Q.60)

A taxpayer’s filing status is determined on the last day of the year (Dec 31).
• Q.10 (Carol): Since her divorce was final during the year, she is considered unmarried for the whole year. Because her nondependent daughter lives with her, she pays more than half the cost of keeping up a home, and her daughter is a qualifying person, her correct status is Head of Household (HOH).
• Q.60 (Qualifying Widow[er]): A QW gets the Married Filing Jointly (MFJ) standard deduction, which is the most favorable.

Cost of Maintenance (Q.16)

For HOH status, the taxpayer must pay >50% of the cost of maintaining the home. These costs include property taxes, mortgage interest, rent, utilities, and food consumed in the home. It does *not* include the mortgage principal payment, which is a return of capital, not an operating cost.

Dependency Tests (Q.11, Q.20, Q.21, Q.27, Q.48)

A dependent must be a Qualifying Child (QC) or Qualifying Relative (QR).
• Citizenship Test (Q.20, Q.27): A dependent must be a U.S. citizen, U.S. national, or a resident of the U.S., Canada, or Mexico. A U.S. national (e.g., a resident of American Samoa) meets this test.
• Tie-Breaker Rules (Q.11): If a child qualifies for more than one person, the IRS tie-breaker rules apply. The parent the child lived with longer has the primary claim. If the child lived with both parents equally, the parent with the higher AGI has the claim.
• Noncustodial Parent (Q.48): The noncustodial parent can only claim the child if the custodial parent signs Form 8332, Release/Revocation of Release of Claim to Exemption for Child by Custodial Parent.
• Married Dependents (Q.21 – Rachel): A taxpayer cannot claim a dependent who files a joint return. The *exception* is if the dependent (Rachel and Mike) are only filing jointly to claim a refund of all taxes paid (i.e., they have no tax liability). Since Mike earned $24,500, he will have a tax liability, so this exception does not apply. Jerry and Diana cannot claim Rachel if she files MFJ with Mike.

Theme 2: Income, Wages, and AGI

This section covers Questions: 9, 30, 43, 45, 51, 58

Calculating AGI (Q.9)

Adjusted Gross Income (AGI) is gross income minus “adjustments to income.”
• Q.9 (Fred/Dolores): Gross income includes Wages ($10,000) and U.S. Treasury Bond Interest ($325). Social Security ($5,000) is not taxable at their low income level. Gifts ($500) are never taxable to the recipient.
• AGI = $10,000 + $325 = $10,325.

Taxable Interest & Dividends (Q.30, Q.45, Q.51, Q.58)

• Q.45 (Tax-Exempt): Interest on U.S. bonds *is* federally taxable. Interest on state/municipal bonds (e.g., New York state bonds) is generally *not* federally taxable.
• Q.30 & Q.58 (Dividends): Ordinary dividends are in Box 1a of Form 1099-DIV. Credit union “dividends” are actually interest and are reported on Form 1099-INT.
• Q.51 (William/Jackie): Taxable dividends are: Oak Farms ($826) + Craft Inc. ($597) + Frankfort Mutual Fund ($283) = $1,706. The credit union dividends ($232) are interest. The bond interest ($521, $375, $64) is interest. The private contract interest ($1,263) is also interest.

Other Income (Q.43)

Q.43 (Child Support): Child support payments are not taxable income to the recipient and are not deductible by the payer. They are not considered “earned income” for the EITC.

Theme 3: Retirement, IRAs, and Pensions

This section covers Questions: 3, 8, 14, 15, 18, 24, 28, 31, 33, 35, 41, 54, 56

Taxable Pensions (Q.3, Q.33)

• Q.3 & Q.33 (1099-R): If a 1099-R has a blank Box 2a and “taxable amount not determined” is checked, it means the taxpayer has a “cost basis” (after-tax contributions). For pensions starting after 11/18/1996, the Simplified Method must be used to calculate the tax-free portion of each payment.

IRA Contributions (Q.18, 24, 28, 31, 41, 56)

• Q.24 (Roth IRA Age): There is no age requirement to contribute to a Roth IRA, as long as the person has earned income (compensation).
• Q.31 & Q.56 (IRA Deduction): A taxpayer *not* covered by an employer plan (like Brian, Q.56) can deduct their full IRA contribution ($5,500 for 2018) regardless of income. A taxpayer *covered* by a plan (like Lloyd, Q.31) has AGI limits.
• Q.18 (Jasmine): Her 2018 MAGI of $75,000 is *over* the phase-out for a single filer covered by a plan ($63,000-$73,000). Her deductible adjustment is $0.
• Q.28 & Q.41 (Spousal IRA): A spousal IRA allows a working spouse to contribute on behalf of a non-working or low-earning spouse, as long as they file MFJ and have enough compensation. For Q.41, Joe (52) and Gail (49) can contribute a total of $12,000 ($6,500 for Joe, $5,500 for Gail). Since Joe only put in $4,500, they can still contribute the full $5,500 to Gail’s IRA.

Retirement Plans & Conversions (Q.8, Q.15)

• Q.8 (SIMPLE IRA): An employer with a SIMPLE IRA receives a deduction for the contributions they make. They must either match employee contributions or make a nonelective contribution to all employees.
• Q.15 (Roth Conversion): When converting a traditional IRA to a Roth IRA, the taxpayer must pay income tax on the pre-tax portion of the transferred amount in the year of conversion. The statement that tax is paid later is incorrect.

Early Distribution Penalty (Q.14, Q.35, Q.54)

• Q.14 & Q.54 (Exceptions): The 10% early withdrawal penalty has exceptions. A 401(k) distribution for higher education (Q.14) is *not* an exception (it *is* for an IRA). A 401(k) distribution to a taxpayer who separates from service after age 55 *is* an exception (Q.54).
• Q.35 (RMD Penalty): To waive the 50% penalty for failing to take an RMD, you must file Form 5329, prove reasonable error, and show you are taking steps to fix it. You are *not* required to withdraw double the RMD.

Theme 4: Tax Credits (Education, Dependent, Adoption)

This section covers Questions: 2, 6, 12, 22, 25, 26, 32, 36, 37, 40, 42, 46

Child and Dependent Care Credit (Q.2, Q.6, Q.40, Q.52)

• Q.2 & Q.6: Employer-provided dependent care benefits (reported in Box 10 of Form W-2) are subtracted from the total expenses on Form 2441.
• Q.40 (John/Sarah): The 14-year-old is *not* a qualifying child for this credit (must be under 13). They paid $4,600 for two children, but the maximum qualifying expense for 2+ children is $6,000. Their AGI is $41,000, giving them a credit rate of 21%. $4,600 * 0.21 = $966. (Note: The provided answers seem off; $990 is 21.5%, which is not a valid rate). *Self-correction: Ah, the $4,600 is for *two* children, $2,300 each. The max for *one* child is $3,000. Wait, the $4,600 is the total. The AGI is $41,000, which has a 21% rate. $4,600 x 0.21 = $966. None of the answers are correct based on 2018 rules. However, $990 would be 21.5%… Let’s re-read. $41,000 AGI. Credit rate is 21%. Max expenses for 2 children is $6,000. They paid $4,600. $4,600 * 0.21 = $966. The provided answer key is likely flawed, but $990 would be the answer if the rate was 21.5% or AGI was $40,000 (22%). Let’s assume AGI is $40,000, rate 22%. $4,600 * 0.22 = $1012. That’s an option. Let’s assume AGI $41,000 is rate 21%. $4,600 * 0.21 = $966. Let’s assume the expenses were $4,714 * 0.21 = $990. This question is problematic, but the closest logic is $4,600 x 21% = $966, or $4,600 x 22% = $1012. $990 is likely based on an AGI of $40,000 ($4,500 * 22%). This question is flawed.*
• Q.52 (Age 13): A child is considered to have turned 13 on the day of their birthday.

Education Credits (Q.22, Q.25, Q.26, Q.32, Q.46)

• Q.25 (AOTC): The AOTC is only for the first 4 years of *undergraduate* study. This disqualifies Julie (MA student) and the secondary school student. A dependent (Mary) cannot claim their own credit. Jerry’s son (sophomore) is the only eligible individual.
• Q.22 (Scholarship): A scholarship is tax-free *only* if used for qualified education expenses (tuition, fees, books). Since her $4,000 scholarship was less than her tuition, $0 is taxable.
• Q.32 (LLC): The Lifetime Learning Credit is $2,000 per return.
• Q.26 & Q.46 (Refunds): If an education credit is received and the school later issues a refund, part of the credit may have to be recaptured (paid back) in the year the refund is received. Tax-free employer assistance (Q.46) cannot be used for any credit.

Other Credits (Q.12, Q.36, Q.37, Q.42)

• Q.12 & Q.36 (CTC/ODC): The Child Tax Credit (CTC) requires the child to be under age 17. For Jennifer (Q.36), Sydney (7) and Patrick (11) qualify for the $2,000 CTC each ($4,000). Joanna (17) qualifies for the $500 Credit for Other Dependents (ODC). Total credit = $4,500. This is less than her tax liability, so she gets the full amount.
• Q.42 (Adoption Credit): The maximum credit is $13,810 (for 2018) *per child*, not per return.
• Q.37 (Mortgage Credit): This credit requires a Mortgage Credit Certificate (MCC) from a state or local government.

Theme 5: Preparer Due Diligence & Ethics

This section covers Questions: 5, 13, 19, 23, 29, 34, 38, 39, 44, 47, 49, 50, 53, 59

Preparer Responsibilities (Q.5, 19, 34, 44)

• Q.5 (Noncompliance): If a preparer knows a client is noncompliant, they must advise the client promptly of the consequences. They are *not* required to notify the IRS.
• Q.19, 34, 44 (Filing Issues): Noncompliance includes reporting inaccurate income or claiming false deductions. If a client (Jeff, Q.34) admits to not filing in prior years, the preparer should file the current year return but advise the client of the law and encourage them to file back taxes. Due Diligence (Q.13, 29, 38, 47, 59)

• Q.13 & Q.59 (Form 8867): This checklist is required for EITC, AOTC, and CTC/ACTC. It ensures the preparer considered all due diligence requirements, which includes asking questions, documenting answers, and retaining copies of taxpayer documents. It does *not* require the preparer to “investigate and verify” information, only to ask probing questions if it appears incorrect.
• Q.29 (AOTC Docs): A 1098-T is not strictly required. The preparer can use a billing statement and receipts, but they must document the questions asked to determine eligibility (D).
• Q.38 & Q.47 (Record Keeping): Preparers should document questions/answers on every tax return, not just EITC.
• Q.23, 49, 50 (Inconsistent Info): If a client’s info seems inconsistent (Josh, Q.49) or ineligible (Mary, Q.23; John/Lois, Q.50), the preparer must ask clarifying questions. They cannot knowingly file an incorrect return. The correct action for John/Lois (Q.50) is to explain the tie-breaker rules (which favor the parent, June) and state they can only claim Jessica if June agrees not to.

Other Rules (Q.39, Q.53)

• Q.39 (Sec 7525): This “preparer privilege” applies to tax advice but *not* to criminal tax matters or simply preparing the return.
• Q.53 (Rejections): The most common e-file rejections are TIN/name mismatches, a TIN used on another return, or an incorrect prior-year AGI. Relying on nonstandard documents is a *preparer* error, not an *e-file* rejection reason.

Theme 6: Health Insurance & Other Taxes

This section covers Questions: 4, 7, 55

• Q.7 (Marketplace): Health insurance from the Marketplace (Healthcare.gov) is reported on Form 1095-A.
• Q.55 (Employer Insurance): The cost of employer-provided health insurance is reported in Box 12, Code DD on Form W-2.
• Q.4 (Social Security Tax): For 2018, the SS wage base was $128,400. The employee tax rate is 6.2%. The maximum tax was $128,400 * 0.062 = $7,960.80.