Chapter Five

Chapter Five
Accounting Methods and Periods, and Computation of
Tax Liability and Tax Credits
ACCOUNTING METHODS ……………………………………………………..5-1
General
Cash method
Accrual Method
Hybrid Method
Constructive Receipt
Installment Sales
Completed Contract Sales

ACCOUNTING PERIODS ……………………………..…..….…………………5-4

COMPUTATION OF AN INDIVIDUAL'S TAX LIABILITY AND CREDITS………………...5-4

Regular Computation
Dependent Child
Child Under the Age of 14-Kiddie Tax
Phase-Out of Exemptions
Income Averaging for Farmers

ALTERNATIVE MINIMUM TAX ……………………………………..………..5-7

Adjustments
Tax Preferences
Exemption Amount
The AMT Tax Rate

SELF –EMPLOUMENT TAX ……………………………………………………5-9

COMPUTATION OF TAX CREDITS ………….………………………...……5-10

Earned Income Credits
Child Tax Credit
HOPE Scholarship Credit
Lifetime Learning Credit
Dependent Care credit
Elderly Credit
Foreign Tax Credit
Excess Social Security Taxes

ESTIMATED INCOME TAX PAYMENTS ……………………..…………….5-13

1998 TAX RATE SCHEDULE …………………...……………………………..5-14

Chapter Five
Accounting Methods and Periods, and Computation of
Tax Liability and Tax Credits

ACCOUNTING METHODS

GENERAL
A taxpayer may report income and deductions under the method that
he regularly keeps his books and records. However. If the IRS does
not believe that the books and records accurately reflect the taxable
income of the taxpayer, the IRS may change that method. There are
also approved methods, subject to restrictions, that the IRS allows.

CASH METHOD
Under the cash method of accounting, income is recognized income
when the taxpayer actually receives the cash, or it is constructively
received. Deductions are allowed when the cash is paid. This method
is not limited solely to the receipt and payment of cash. The receipt,
or payment, may be in the form of services or property using the fair
market value.
The cash method is not available to those taxpayers where inventory
is a material income producing factor. Where inventory is a factor,
the accrual method must be used. It is also not available to C
Corporations, unless their sales are less than $5 million per year.
Under the cash method, certain prepaid expenses may be allowed as
a current year deduction if the deferral period is less than a year.
Also, charging an item to the taxpayer's credit card constitutes a
payment in the year charged, even though the taxpayer does not pay
the credit card company until the following year. Purchases of fixed
assets for cash, however, are not treated as expenses. The assets
must be capitalized, and deductions are allowed through cost
recovery (depreciation).
Prepaid income or deferred revenue is usually recognized in the year
of receipt even though it is not earned until next year. An exception
from income treatment is the receipt of a security deposit where the
amount will be returned to the tenant at the end of the lease.

ACCRUAL METHOD
Under the accrual method of accounting, income is recognized
when earned and expenses when incurred. The general rule
addressing the concept of “recognized when earned or incurred”
states that:
 All of the events fixing the taxpayer's right to receive the income , or create
the liability have occurred , and
 The amount can be determined with reasonable accuracy.
The issue of reasonable accuracy allows the taxpayer to file a return
even when there is some degree of uncertainty as to the actual
receipt of income or the payment of expense. Under this premise,
when the actual amount is determined in a later year, an amended
return is not required.
When inventory is a material income producing factor, the taxpayer
must report actual sales, and determine the cost of goods sold using
inventory and accounts payable.

Example 1: T has a retail store and during the year the actual sales were $400.000. T's
beginning and ending inventory was $30.000 and $45.000 respectively. Cash
purchases during the year totaled $310.000 and his trade payables at the beginning
and end of the year were $28.000 and $31.000 respectively. T must report the
following gross profit.
Sales $400.000
Cost of goods sold
Beginning inventory 30.000
Purchases 313.000
Goods available for sale 343.000
Ending inventory -45.000
Cost of goods sold 298.000
Gross profit on sales $102.000
(Hint: Cash purchases plus ending trade payables minus beginning trade payables
equals purchases under the accrual method.)

HYBRID METHOD
The taxpayer maintaining an inventory is required to use the
accrual method for reporting the gross profit on sales. However,
for the other expenses such as selling and administrative, the
taxpayer may use the cash method.

CONSTRUCTIVE RECEIPT
Even though a taxpayer does not actually receive the cash, they
may still have to recognize income under the constructive
receipt doctrine. This doctrine states that income is to be
recognized when the money or property is made available to the
taxpayer and there are no real limitations to the taxpayer
receiving it.
Example 2: Z performed cleaning services during November 1999 and billed the
client $500. The client paid Z the $500 on December 28, but Z refused to accept
payment and asked to be paid in 2000 instead. Z constructively received the income in
1998 and must include it in income.

Example 3: W is a shareholder of a Fortune 500 company. On December 31, the

company declared and paid a dividend on their stock. The company mailed W a
dividend check for $200 on that date. W received the check on January 4, 2000. W
did not have access to the funds until 2000. W does not include this as 1999 income.

INSTALLMENT SALES
When a taxpayer sells property and recognizes again, the
taxpayer does not have to recognize the entire gain from the sale
if at least one payment is received in the year after the sale.
Under the "where-with-all-to-pay concept”, the gain is
recognized on a pro-rata basis based upon the receipt of the sale
proceeds. This is not an elective provision, it is automatic. If you
want to recognize all of the income in the year of the sale, you
must elect out by reporting the entire gain in the year of the sale.
To determine the recognized gain for the year:
Total gain × Payments received during year = Recognized gain
Total contract price

Example 4: In 1997, D sells property to B for $40.000. D's cost in the asset was
$30.000, thus a $10.000 gain is to be recognized. D is to receive $20.000 in 1997 and
$10.000 in 1998 and 1999. Under the installment sale provision D would recognize
$5.000 in 1997, and $2.500in cash of 1998 and 1999.

1997 gain $10.000 × $20.000 = $5.000

 $40.000

1998 & 1999 gain $10.000 × $10.000 = $2.500

$40.000

Should the buyer assume any indebtedness on the property

being sold, then the denominator should reflect that as a
reduction from the overall selling price or contract price. The
installment sale provisions are not available for the ordinary
gain on the sale of inventory or depreciation recapture from the
sale of depreciable property. That gain is recognized
immediately.

COMPLETED CONTRACT SALES

When a taxpayer is involved in a project which extends beyond
the tax year, it may be possible to defer the gain on the project
until it is complete. The completed contract method usually is
associated with home builders, commercial contractors, road
construction, etc. Costs associated with the contract are
accumulated as an asset until the project is complete. At that
time, the total revenue and costs associated with that project are
recognized for tax purposes. In order to qualify, the company's
gross receipt must not exceed $10 million.
The alternative is the percentage of completion method; the
taxpayer recognizes income on a pro-rata basis as the job
progresses.

Example 5: ELK Company builds commercial projects, and during the current year
expended $3.000.000 in material, labor and overhead on their only project. The total
revenue at completion will be $6.000.000 and it is estimated that it will take
$1.500.000 to complete the project.
Under the completed contract method, no income or expense would be recognized in
the current year because the job is not complete. Under the percentage of completion
method , ELK would recognize $1.000.000 in income , determined as follows :

Costs incurred to date $3.000.000 × Total revenue $6.000.000 = $4.000.000

Estimated at completion $4.500.000

Total revenue to be recognized $4.000.000

Cost of construction 3.000.000
Income recognized $1.000.000
ACCOUNTING PERIODS
In general, a taxpayer may select a year-end to coincide with the
method used to maintain his books and records. However, most
individual taxpayers use a calendar year due to the record
keeping complexities. (S Corporations and partnerships have
other restrictions which are addressed in Chapter 7, 8 and 9.)
The length of the tax year cannot exceed 12 months. However, it
is permissible for a taxpayer to use a 52 or 53 week to coincide
with the natural business cycle.

Example 6: J is a grocer and is open Monday through Saturday. J elects to have his
tax year end on the last Saturday in December to coincide with his business cycle.
Some years this results in a 52 week year, and others a 53 week year.
Once a year-end is selected, the taxpayer must obtain written
consent from the IRS in order to change. The request is filed on
Form 1128 and is due on or before the 15th day of the second
month following the desired year-end. This results in what is
referred to as a short period. The income from the short period
must be annualized to determine the appropriate tax effect.

Example 7 : SSC Academy has a December 31 ( calendar ) year-end and wishes to

change to June 30th to coincide with their natural year-end . They must file the request
no later than August 15th , and if approved , file a short period return covering the
period from January 1 until June 30 .

COMPUTATION OF INDIVIDUAL'S TAX LIABILITY AND CREDITS

GENERAL

Once the taxable income of an individual has been determined,

the computation of tax is required. After the tax is computed, a
reduction for payments and credits is made to determine if the
individual has a refund or balance due See page two of Form
1040 at the back of Chapter 1 for a complete look at the taxes
and credits.
The summary of the major tax computations, credits and
payments, is as follows:
Taxable income
Tax (regular)
Less: Child and dependent care credit
Elderly credit
Foreign tax credit
Plus: Self-employment tax
Alternative minimum tax
Penalty tax on IRS and pensions
Less: Withholding taxes
Estimated tax payments
Earned income credit
Excess Social Security tax
Refund or balance due

REGULAR COMPUTATION
In computing the amount of tax, taxpayers with taxable income
of less than $100.000 may use the Tax Tables. If you are
required to calculate the tax on the exam, you will use the rates,
not the tax tables. Please refer to the 1999 Rate Schedules for
the different filing statuses on the last page of this Chapter.
The rate schedule for an unmarried taxpayer (single), shows that
the taxis 15% for the first $25.750 of taxable income; 28% on
the taxable income from $25.750 through $62.450 and so on.
The highest marginal tax bracket for an individual is 39.6%

Example 8 : W is single and has taxable income of $35.750 . His tax is computed as
follows :
$25.750× 15% $3.862
$10.000× 28% 2.800
Total tax $ 6.662

The rate that the taxpayer is taxed on for the incremental amount
of income is called the marginal tax bracket. W is in the 28%
marginal tax bracket. W's average tax rate is 19%
($6.603/$35.350).

DEPENDENT CHILD
In preparing the return for a dependent child, no personal
exemption is allowed. This is because someone has already
claimed the child as a dependent. Another important factor is
that the dependent's standard deduction is limited to the amount
of earned income, plus $250 (but not to exceed $4.300) or $700,
whichever is greater.

Example 9: S is 16 and is properly claimed as a dependent on his parent's return.

During 1999 S earned $5.300 working in a supermarket. He has no other income.
Gross income $5.300
Standard deduction -1.300
Taxable income $1.000

Tax @ 15% $ 150

Example 10: T is 16 and is properly claimed as a dependent on his parent's return.

During 1999, T received $5.000 from investments given to him by his grandparents.
He has no other income.
Gross income $5.000
Standard deduction -700
Taxable income $4.300

Tax @ 15% $645

Since the $5.000 is not considered earned income , the standard deduction is limited to $700

CHILD UNDER THE AGE OF 14-KIDDIE TAX

When a child under the age of 14 has net unearned income in
excess of $1.400, the tax on the excess will be taxed at the
parent's rate. The computations are somewhat complicated due
to the use of the exemptions and standard deduction, but the
thrust of the law is to counter the tax planning technique of
shifting income producing property (investments) down to a
child where it will be subject to a lower tax rate. At the child's
level, effectively the first $700 of income is not subject to tax
because of the standard deduction, the second $700 is taxed at
the child's rate (15%), and the excess is taxed at the parent's rate.
Example 11: N, age 4, received $4.700 in interest and dividends during 1999. N had
no itemized deductions. N's parents are in the 28% tax bracket.
Total unearned income $4.700
Less : Standard deduction -700
Amount subject to tax 4.000
Less : Amount taxed at child's rate -700
Amount taxed at parent's rate $3.300

Tax on child's portion :

$700× 15% = $ 105
Tax on parental portion :
$3.300× 28% = 924
Total tax $1.029
As an option to performing the above calculations and filing a
return for their child, parents may pay an additional $105 tax
plus claim the unearned income in excess of $1.400 on their
return. To elect this, the gross income must be from interest and
dividends only, and must be less than $5.000.

PHASE-OUT OF EXEMPTIONS
In determining the tax for high-income taxpayers, the deduction
for exemptions may be eliminated. Taxpayers with adjusted
gross income in excess of a specified threshold amount must
reduce their exemptions by 2% for every $2.500 of fraction
thereof over the threshold. The 1999 thresholds are:

Single $126.600
Married, filing jointly 189.950
Married, filing separately 94.975
Head of household 158.300
Qualifying widow (er) 189.950

Example 12: P is single and has no dependents. His 1998 AGI is $136.550. Calculate
how much of his $2.650 exemption is disallowed under this provision.
P's adjusted gross income $138.650
Threshold amount 126.600
Excess over threshold 12.050
Divided by $2.500 4.82
Round up to next whole number 5
 Statutory percentage 2%
Total percentage reduction 10%
P's exemption $2.750
Disallowed portion of exemption $ 275

INCOME AVERAGE FOR FARMERS

Effective for tax years beginning after December 31, 1997, a
taxpayer engaged in the farming business may now elect to use
income averaging to compute his tax. In determining income,
the farmer may include the gain from the sale of farming
business property.

ALTERNATIVE MINIMUM TAX

GENERAL
To ensure that individuals pay their fair share of taxes, a taxpayer may be
subject to an alternative minimum tax (AMT). The AMT is the excess of
the alternative minimum tax over the regular tax. The process to
determine the AMT is to first identify the various tax preferences or
adjustments which were properly elected and planned for by the taxpayer,
and then, effectively, disallow them.
The framework for calculating the AMT is as follows:

Taxable income
Plus or minus adjustments
Plus the tax preferences
Equals AMTI
Less the exemption amount
Equals the AMT base
Multiplied by the AMT tax rate
Equals the tentative minimum tax
Less the regular tax
Equals the AMT

ADJUSTMENTS
In general, adjustments can be positive or negative, and are the
result of timing differences in the tax treatment of certain items.
For example, excess MACRS depreciation over the longer,
slower AMT depreciation method of ADS (alternative
depreciation system) will result in a positive adjustment that
increases the alternative minimum taxable income. However,
after the asset has been fully recovered under MACRS, there

Will still be depreciation under the AMT method, which will

cause a negative adjustment and decrease AMTI?

The AMT adjustments, with a very brief explanation, include:

 Circulation expenditures – Must be capitalized and expensed over three years,

not immediately.
 Depreciation – Excess MACRS of real property over ADS of 40 years
straight-line.
 Depreciation – Excess MACRS of personal property over ADS 15% DDB.
 Differences in Recognized Gains or Losses –Because of depreciation changes,
tax bases are different.
 Pollution Control Facilities Amortization – Excess of straight-line, 60 months
over ADS.
 Passive Activity Losses – Use a different taxable income level for determining
losses.
 Completed Contract Method – must use percentage of completion instead.
 Incentive Stock Options –Excess of FMV over exercise price.
 Net Operating Loss – Must be modified.

The following itemized deductions are also adjustments, and are

limited in their deductibility for AMT purposes:

 Medical Expenses –Must exceed 10% of AGI instead of 7.5%.

 Taxes –State, local foreign and property –Not allowed.
 Mortgage Interest – Limited to acquisition interest, excludes home equity interest.
 Certain Investment Interest Expense –Not allowed.
 Miscellaneous 2% Deductions –Not allowed.
 Standard Deduction – Not allowed.
 Exemption Amount – Not allowed.

TAX PREFERENCES
Tax preferences are always added to taxable income, never
subtracted. The preferences are:

 Interest income on private activity bonds.

 Excess accelerated depreciation over straight –line on pre-87 real property.
 Excess accelerated depreciation over straight –line on leased pre -87 personal property.
 Excess amortization over depreciation on pre-87 certified pollution control facilities.
 Percentage depletion beyond the property's adjusted basis.
 Excess intangible drilling costs, reduced by 65% of net income from oil, gas and
geothermal activity.
  42% of the excluded gain from the sale of certain small business stock.

EXEMPTION AMOUNT
After adding and subtracting the adjustments, and adding the tax
preferences to taxable income, a taxpayer is allowed an
exemption from the AMTI. The exemption amounts, by filing
status, are follows:
Single $33.750
Married, filing jointly 45.000
Married, filing separately 22.500
However, these exemptions are phased-out (at a rate of 25%
over the excess) if the taxpayers AMTI before the exemption
exceeds the following thresholds:
Single $112.500
Married, filing jointly 150.000
Married, filing separately 75.000

Example 13: R & S are married and file a joint return. R & S had AMTI (before the
exemption amount) of $270.000. Their exemption amount would be only $15.000
($45.000 less phase-out of $30.000).
AMTI $270.000
Threshold for phase-out 150.000
Excess over threshold 120.000
Phase-out rate 25%
Exemption phase out $30.000

THE AMT TAX RATE

There is a two-tier tax for determining the tentative minimum tax.
AMT Base Amount AMT Rate
$0 up to $175.000 26%
$175.000 and up 28%

Example 14: During the year, K earned a significant amount of income and took
advantage of many tax preferences and accelerated depreciation, and paid a large
amount of real estate taxes, income taxes and home equity interest. K calculated her
income tax liability under the regular method to be only $17.000. K then heard about
the alternative minimum tax from a CPA candidate and after hours of calculations,
she determined that her AMT base amount was $205.000.
Tentative minimum tax computation :
First $175.000 @ 26% $45.000
Next $30.000 @ 28% 8.400
 $53.900
K's regular income tax 17.000
Alternative minimum tax $36.900
K was stunned. Remember that the alternative minimum tax is the excess of the
tentative minimum tax over the regular tax

SELF-EMPLOYMENT TAX
If a taxpayer has earnings from self-employment of at least
$400, a self-employment tax must be paid on earnings. The self-
employment tax is equivalent to the employee's share and the
employer's share of the Social Security and Medicare taxes
withholding tax. The rate for Social Security tax is 6.2% and
Medicare is 1.45% for a total of 7.65%. A taxpayer is subject to
the Social Security tax on earnings up to $72.600 in 1999. For
Medicare there is no ceiling. Since the taxpayer is employing
himself, these rates must be doubled to a total rate of 15.3%.
In order to provide the self-employed taxpayer with a benefit for
paying the "employer's share" of the taxes required to be paid,
there are two special provisions:
 Before calculating the tax , the net earnings are reduced by 7.65% and
 One-half of the self-employment tax is allowed as a deduction for adjusted
gross income (Chapter 3).

Example 15: J is self-employed and has $30.000 of net earnings from self-
employment. His self-employment tax is determined as follows :
Net earnings $30.000
Reduction percentage 92.35%
Computation base $ 27.705
Self-employment tax rate 15.3%
Self-employment tax $4.239

COMPUTATION OF TAX CREDITS

GENERAL
Tax credits generally reduce the amount of tax shown on the return. Most
credits require special calculations to determine the amount of the credit
and several are based upon the taxpayer's filing status. Most tax credits
are called non-refundable credits because they can only reduce the tax to
zero. One credit in this section (earned income credit) is a refundable
credit. This credit provides the taxpayer with relief beyond reducing the
tax liability to actually generating a refund, even if no taxes were ever
paid.
Example 16: Y has no taxable income this year and has no tax liability. Y qualifies for
an elderly credit of $60. Y cannot utilize the credit because it is a non-refundable
credit and it cannot reduce his tax below zero. If Y's $60 credit was a refundable
credit (such as the earned income credit), Y would receive a refund of $60, even
though Y had no tax liability nor made any payments.

EARNED INCOME CREDIT

This credit provides qualifying taxpayers with relatively low levels of
income a credit against their tax liability, or a refund, if in excess of their
liability. This is only refundable credit. The nature of the credit is to
encourage the taxpayer to "earn" income, rather than receive "non-
earned" benefits. The credit computation excludes interest, dividends and
alimony from the computation. While the credit was only for taxpayers
with at least one child residing with them for over one-half of the year, it
has been expanded to those without children, as is discussed later.
The credit is subject to phase-out limitations based upon the AGI and
number of qualifying children of the taxpayer. Tax-exempt interest and
any non-taxable pension or annuity income is added to the definition of
AGI. In order to qualify, the child must be a son, daughter, stepson,
stepdaughter or foster child of the taxpayer; must reside with the taxpayer
as their principal place of a bode; and must be under age 19, or 24 if a
full-time student. For 1999, the credit schedule is as follows:
Number of Maximum Credit Phase-out Phase-out Phase-out
Children Earned Income % Amount % Stops
One Child $6.800 34% $12.460 15.98% $26.928
Two or more $9.450 40% $12.460 21.06% $30.580

Example 17: L has only earned income in 1999 of $13.000 and two qualifying
children. Her earned income credit is :
Maximum credit $9.540× 40% = $3.816
Less : phase-out :
$13.000- 12.460 = $540
$540× 21.06% -114
Earned income credit $3.702

If L's tax was only $200, then the credit would reduce the tax to zero and give L a
refund of $3.502.

Taxpayers, between the ages of 25 and 64, without children, and

who are not the dependents of another taxpayer, may qualify for
the earned income credit under RRA of 1993. The credit is at
the rate of 7.65%of earned income up to $4.530. (Maximum
credit is $347). The credit reduces at the same rate by the excess
of earned income over $5.670. The credit is fully phased –out at
$10.200.

CHILD TAX CREDIT

Effective for tax years beginning after December 31, 1997, taxpayers will
be able to claim a child credit for each qualifying child under the age of
17. For 1999, the credit is $500 per child. In general, the child must be a
child or direct descendant of the taxpayer and the taxpayer must be able
to claim the child as a dependent. There is a threshold limitation. The
credit is reduced by $50 for each $1.000 (or part thereof) of modified
adjusted gross income over the following:
Single $75.000
Married filing jointly 110.000
Married filing separately 55.000
The credit has an additional feature in that if it exceeds the taxpayer's
income tax for that year, the excess may be refunded if the taxpayer has
three or more qualifying children, similar to the earned income credit.

HOPE SCHOLARSHIP CREDIT

Effective for tax years beginning after December 31, 1997, taxpayers may
elect to take a nonrefundable tax credit for tuition and fees during the first
two years of postsecondary education. The credit is equal to the lessor of
$1.500 or 100% of the first $1.000 paid plus 50% of the next $1.000 paid.
The credit is determined per student, per year.

LIFETIME LEARNING CREDIT

Effective for payments made after June 30, 1998, taxpayers may
elect to take a nonrefundable tax credit for qualified tuition and
related expenses for undergraduate , graduate and professional
degree courses . The credit is the lessor of $1.000 or 20% of up
to $5.000 in qualified tuition and fees. Unlike the HOPE
Scholarship Credit, the taxpayer may claim this over an
unlimited number of years. However, this credit is not based
upon the number of qualifying students. The maximum credit
per year is $1.000.
There are some limitations to both Hope Scholarship Credit and
Lifetime Learning Credit. The phase-out range (credits are
reduced on a pro-rata basis) for allowing the credits is as
follows:
Phase-out range
Married, filing jointly $80.000 - $ 100.000
Single $ 40.000 - $ 50.000
The credit is not available for married taxpayers filing separately

DEPENDENT CARE CREDIT

This credit applies to those taxpayers who pay for dependent or child care
in order for them to work. To be eligible, the taxpayer must maintain a
household for a dependent age 12 or under, or any dependent of spouse
who is physically or mentally incapacitated. The credit ranges from 30%
down to 20% based upon the AGI of the taxpayer. The credit is reduced
by 1% point for each $2.000 of AGI over $10.000. The 20% credit is
reached when AGI exceeds $28.000.

When computing the credit, there are two other restrictions.

First, the maximum amount of qualifying expenses per child is
$2.400 for one; and $4.800 for two or more. Second, the
maximum amount cannot exceed the earned income of the
spouse with the lower earnings. For purposes of this test,
alimony counts as earned income as does a deemed amount of
$200 per month per child ($2.400 per year) for full-time
students.

ELDERLY CREDIT
A credit is provided to the elderly and disabled to provide a form of
relief from taxation. The credit applies to taxpayers 65 or older.
It is also available to those under 65, provided they are retired with a
total and permanent disability.
To determine the credit, start with an initial base amount (per
Section 37) of $5.000 for a single taxpayer or $7.500 for married
filing jointly. This amount needs to be reduced by
(1) any social security benefits , and
(2) one-half of the excess AGI over $7.500 if single or $10.000 if married

This is the "qualifying income" The credit is the lessor of 15%

of their qualifying income, or the amount of tax on the return.
Example 18: M is 70, single and retired. During the year he earned $3.000 from his
pension and $1.000 in interest on his savings. M has no tax liability. M also received
$1.500 in social security benefits.
 Section 37 amount $5.000
Less : Social Security benefits -1.500
Credit base $3.500
Elderly credit rate 15%
Elderly credit $ 525
Note : This credit is only allowed to offset taxes . His taxes are zero , therefore no credit is allowed .

FOREIGN TAX CREDIT

Individual taxpayers are taxed in the United States on their worldwide income. The
taxpayers are entitled to a tax credit for income taxes paid to foreign countries. This
prevents double taxation of the same income. The foreign tax credit cannot exceed the
lessor of the amount of the foreign taxes paid or pro-rata share of US taxes on the
foreign income. The limitation is determined as follows:

Income from foreign sources × US taxes paid = Foreign tax credit

Worldwide income

Example 19: K has taxable income of $50.000, of which $1.000 was dividends earned
on an investment in a foreign country. K paid $300 in income taxes to that foreign
country. Prior to the determination of the foreign tax credit , K's US income tax was
$10.000
$1.000 × $10.000 = $200maximum foreign tax credit
$50.000
The foreign tax credit is $200 (the lessor of $200 or the amount paid of $300). The
excess of $100 may be carried back two years and then forward five years.

EXCESS SOCIAL SECURITY TAXES

A taxpayer is generally subject to Social Security and Medicare taxes. For
1999, the Social Security tax of 6.2% is imposed on wages up to $72.600
per year for a maximum of $4.501, while the Medicare tax of 1.45% has
no limit .Earnings above the threshold are not subject to the tax. Should
an employee change jobs during the year, the new employer must
withhold the Social Security and Medicare tax, subject to the same
limitations again. It is possible for taxpayers to have extra Social Security
taxes withheld because of this. This excess may be claimed as a credit
against any taxes due.
Example 20: During 1999, G worked for ABC Company for six months and earned
$40.000 in salary. Social Security taxes of $2.480 were withheld. In July, G began
work for a new company and eared $50.000 for the balance of the year. Social
Security taxes of $3.100 were withheld on those earnings. The maximum wages on
which Social Security taxes may be withheld is $72.600. Therefore, G is entitled to a
credit of $1.079 for 1999.

Social Security wage base $72.600

Social Security rate 6.2%
Ceiling on Social Security taxes $4.501
 Actual Social Security withholdings :
Job # 1 $2.480
Job # 2 3.100
Total withholdings 5.580
Maximum social security tax 4.501
Excess withholdings $ 1.079

ESTIMATED INCOME TAX PAYMENTS

Effective for the tax years beginning after 1997, an individual must make
estimated payments if he expects that the underpayment after
withholdings and tax credits is at least $1.000 and more than 10% of the
amount of the tax shown on the return. The tax payments are remitted
with Form 1040-ES and are due in equal installments on the 15th day of
the 4th, 6th, and 9th month of the tax year, and the 1st month of the filing
year. In order to avoid any penalty on the underpayment of taxes, an
individual must make payments equal to:
 90%of their current year's tax.
 100% of their prior year's tax
 110% of their prior year's tax if the prior year's AGI exceeds $150.000.
 105% of their prior year's tax for tax years beginning in 1999 and 2000.
 Annualized income installment method computation.
 1999 TAX RATE SCHEDULE
Joint Returns and Surviving Spouses Unmarried Individuals (Single)
If taxable income is: The tax is : If taxable income is: The tax is :
Not over $43.050 15% of taxable income Not over $25.750 15% of taxable income
Over 43.050 but not $6.457.50 plus 28%of the Over $25.750 but not $3.862.50 plus 28% of
over $104 .050 exceeds over $43.050 over $62.450 the excess over
$ 25.750
Over $104.050 but not $23.537.50 plus 31%of Over $62.450 but not $14.138.50 plus 31%
over $158.550 the excess over $104.050 over $130.250 of the excess over
$62.450
Over $158.550 but not $40.432.50 plus 36%of Over $130.250 but $35.156.50 plus 36%
over $283.150 the excess over $158.550 not over $283.150 of the excess over
$130.250
Over $283.150 $85.288.50 plus 39.6%
of the excess over Over $283.150 $90.200.50 plus 39.6%
$283.150 of the excess over
$283.150

Head of Households Married Individuals Filing Separately

If taxable income is: The tax is : If taxable income is: The tax is :
Not over $34.550 15% of taxable income Not over $21.525 15% of taxable income
Over $34.550 but not $5.182.50 plus 28% of Over $21.525 but not $3.228.75 plus 28% of the
over $89.150 the excess over $34.550 over $52.025 excess over $21.525
Over $89.150 but not $20.470.50 plus 31% of Over $52.025 but not $11.768.75 plus 31% of the
over $144.400 the excess over $89.150 over $79.275 the excess over $52.025
Over $144.400 but not $37.598 plus 36% of Over $79.275 but not $20.216.25 plus 36% of
over $283.150 the excess over $144.400 over $141.575 the excess over $79.275
Over $283.150 $87.548 plus 39.6% of Over $141.575 $42.644.25 plus 39.6% of
The excess over $283.150 the excess over $141.575
 Chapter Five –Questions
Accounting Methods and Periods, and Computation of Tax
Liability and Tax Credits
ACCOUNTING METHODS & PERIODS Carl also received the following dividends in 1999
from:
1. A cash –basis taxpayer should report gross income Mutual Life Insurance Co, on Carl's
a. For year in which income is either actually or life insurance policy $300
constructively received, whether in cash or in General Merchandise Corp, a Texas
property. corporation, on preferred stock 400
b. For the year in which income is either actually or Second National Bank, on bank's
constructively received in cash only . common stock 800
c. Only for the year in which income is actually
received whether in cash or in property. On July 1 , 1999 , Carl sold for $9.500 , on the open
d. Only for the year in which income is actually market , a $10.000 face value 10-year , noncallable ,
received in cash. Doe Corp bond . This bond was part of an original
issue by Doe on July 1, 1996 and was purchased by
Carl on that date, at a discount of $1.200, for a net
2. Alex Burg, a cash basis taxpayer, earned an annual price of $8.800.
salary of $80.000 at Ace Corp in 1999, but elected to
take only $50.000. Ace, which was financially able to 3. How much should Carl report on his 1999 income
pay Burg's full salary, credited the unpaid balance of tax return as compensation income received from
$30.000 to Burg's account on the corporate books in Canova?
1999, and actually paid this $30.000 to Burg on April a. $50.000
30, 2000. How much of the salary is taxable to Burg b. $51.000
in 1999? c. $52.000
a. $50.000 d. $53.000
b. $60.000
c. $65.000 4. How much rent income should Carl report in his
d. $80.000 1999 income tax return for the amounts paid to him by
Boss ?
a. $6.000
Items 3 through 6 are based on the following data: b. $6.500
Carl Tice, an employee of Canova Corp, received a c. $7.500
salary of 50.000 from Canova in 1999. Also in 1999, d. $8.000
Carl bought 100 shares of Nolan Corp. common stock
from Canova for $30 a share, when the market value 5. How much dividend income should Carl report in
of the Nolan stock was $50 a share. Canova had paid his 1999 income tax return?
$20 a share for the Nolan stock in 1975. In addition, a. $400
Carl owned a building which he leased to Boss Co. on b. $1.100
January 1 , 1999 , for a five-year term at $500 a month c. $1.200
. Boss paid Carl $8.000 in 1999 to cover the d. $1.500
following:
6. What is Carl's long-term capital gain in 1999, on
Rent for January to December 1999 $6.000 the sale of the Doe bond?
Advance rent for January 2000 500 a. $0
Security deposit, to be applied against b. $460
the final three month's rent in the c. $700
fifth year of the lease 1.500 d. $1.200
7. On December 15, 1999, Donald Calder made a Paid within two months as patients collect from
contribution of $500 to a qualified charitable insurance companies. Information relating to this year
organization by charging the contribution on his bank is as follows:
credit card. Calder paid the $500 on January 20.2000,
upon receipt of the bill from the bank. In addition, Cash received at the time of office
Calder issued and delivered a promissory note for visits $35.000
$1.000 to another qualified charitable organization on Collections on accounts
November 1, 1999, which he paid upon maturity six receivable 130.000
months later. If Calder itemizes his deductions, what Accounts receivable,
portion of these contributions is deductible in 1999? January 1 16.000
a. 0 Accounts receivable,
b. $500 December 31 20.000
c. $1.000
d. $1.500
Dr. Chester's gross income from his medical practice
8. In 1998, Farb, a cash basis individual taxpayer, for the taxable year is:
received an $8.000 invoice for personal property a. $165.000
taxes. Believing the amount to be overstated by b. $169.000
$5.000, Farb paid the invoiced amount under protest c. $181.000
and immediately started legal action to recover the d. $185.000
overstatement. In November 1999, the matter was
resolved in Farb's favor, and he received a $5.000
refund. Farb itemizes his deductions on his tax returns. 11. For a cash basis taxpayer, gain or loss on a year-
Which of the following statements is correct regarding end sale of listed stock arises on the
the deductibility of the property taxes? a. Trade date
a. Farb should deduct $8.000 in his 1998 income tax b. Settlement date
return and should report the $5.000 refund as income c. Date of receipt of cash proceeds.
in his 1999 income tax return. d. Date of delivery of stock certificate.
b. Farb should not deduct any amount in his 1998
income tax return and should deduct $3.000 in his
1999 income tax return. 12. Carl Slater was the sole proprietor of a high-
c. Farb should deduct $3.000 in his 1998 income tax volume drug store which he owned for 25 years before
return. he sold it to Statewide Drug Stores , Inc ., in 1999 .
d. Farb should not deduct any amount in his 1998 Besides the $80.000 selling price for the store's
income tax return when originally filed, and should tangible assets and goodwill, Slater received a lump
file an amended 1998 income tax return in 1999. sum of $60.000 in 1999 for his agreement not to
operate a competing enterprise within ten miles of the
Unless the Internal Revenue Service consents to a store's location, for a period of six years. How will the
change of method, the accrual method of tax reporting $60.000 be taxed to Slater?
is mandatory for a sole proprietor when there are a. As $60.000 ordinary income in 1999.
Year-end b. As $60.000 short-term capital gain in 1999.
Accounts receivable merchandise c. As $60.000 long-term capital gain in 1999.
For service rendered inventories d. As ordinary income of $10.000 a year for six years .
a. Yes Yes
b. Yes No COMPUTATION OF TAX LIABILITY AND
c. No No CREDITS
d. No Yes 13. The alternative minimum tax (AMT) is computed
as the
10. Dr. Chester is a cash basis taxpayer. His office a. Excess of the regular tax over the tentative AMT.
visit charges are usually paid on the date of visit or b. Excess of the tentative AMT over the regular tax.
within one month. However, services rendered outside c. The tentative AMT plus the regular tax.
the office are billed weekly, and are usually d. Lesser of the tentative AMT or the regular tax.
 14. In 1999, Don Mills, a single taxpayer, had $70.000 in 18. To qualify for the child care credit on a joint
taxable income before personal exemptions. Mills had no return, at least one spouse must
tax preferences. His itemized deductions were as follows:
Have adjusted Be gainfully employed
State and local income taxes $5.000 Gross income of when related expenses
Home mortgage interest on loan to $10.000 or less are incurred
acquire residence 6.000
Miscellaneous deductions that exceed a. Yes Yes
2% of adjusted gross income 2.000 b. No No
c. Yes No
What amount did Mills report as alternative minimum d. No Yes
taxable income before the AMT exemption?
a. $72.000
b. $75.000 19. Nancy and Denis Martin are married and file a
c. $77.000 joint income tax return. Both were employed during
d. $83.000 the year and earned the following salaries:

Dennis $32.000
15. Alternative minimum tax preferences include Nancy 14.000

Tax exempt Charitable In order to enable Nancy to work, she incurred at-
interest from private contributions of home child care expenses of $6.000 for their two-
activity bonds appreciated capital year-old daughter and four –year-old son. What is the
issued during 1994 gain property amount of the child care credit they can claim?
a. $400 .
a. Yes Yes b. $960 .
b. Yes No c. $1.200 .
c. No Yes d. $2.800 .
d. No No

20 Nora Hayes, a widow, maintains a home for herself

16. The credit for prior year alternative minimum tax and her two dependent preschool children. Nora's
liability may be carried earned income and adjusted gross income was
a. Forward for a maximum of 5 years . $29.000. She paid work-related expenses of $3.000 for
b. Back to the 3 preceding years or carried forward for a a housekeeper to care for children. How much can
maximum of 5 years. Nora claim for child care credit?
c. Back to the 3 preceding years . a. $0
d. Forward indefinitely. b. $480
c. $600
d. $960
17. Which of the following credits is a combination of
several tax credits to provide uniform rules for the current 21. Which of the following credits can result in a
and carry back –carryover years? refund even if the individual had no income tax
a. General business credit. liability?
b. Foreign tax credit. a. Credit for prior year maximum tax.
c. Minimum tax credit. b. Elderly and permanently and totally disabled credit.
d. Enhanced oil recovery credit. c. Earned income credit.
d. Child and dependent care credit.
22. Kent qualified for the earned income credit in 1999. 26. Chris Baker's adjusted gross income on her 1998
This credit could result in a tax return was $160.000. The amount covered a 12-
a. Refund even if Kent had no tax withheld from wages. month period. For the 1999 tax year, Baker may avoid
b. Refund only if Kent had tax withheld from wages. the penalty for the underpayment of estimated tax if
c. Carry back or carry forward for any unused portion. the timely estimated tax payments equal the required
d. Subtraction from adjusted gross income to arrive at table annual amount of
income. 1. 90% of the tax on the return for the current year
paid in four equal installments.
23. Amos Kettle, a single taxpayer, age 66, filed his 2. 100% of prior year's tax liability paid in four equal
income tax return and reported an adjusted gross income of installments.
$6.000. He received a total of $1.200 in Social Security
benefits for the year and has no other excluded pension or a. I only.
annuity amounts. What amount can Kettle claim as a tax b. II only.
credit for the elderly? c. both I and II .
a. $180. d. Neither I nor II.
b. $195.
c. $570. Released and Author Constructed
d. $900. Questions
24. Melvin Crane is 66 years old, and his wife, Matilda, is R98
65. They filed a joint income tax return this year, reporting
an adjusted gross income of $7.800, on which they paid a 27. Krete, an unmarried taxpayer with income
tax of $60. They received $1.250 from social security exclusively from wages, filed her initial income tax
benefits. How much can they claim on Schedule R of return for the 1999 calendar year. By December 31,
Form 1040 as a credit for the elderly? 1999, Krete's employer had withheld $16.000 in
a. $0. federal income taxes and Kerte had made no estimated
b. $60. tax payments. On April 15, 2000, Krete timely filed an
c. $938. extension request to file her individual tax return and
d. $375. paid $300 of additional taxes. Krete's 1999 income tax
liability was $16.500 when she timely filed her return
25. An employee who has had social security tax withheld on April 30, 2000, and paid the remaining income tax
in an amount greater than the maximum for a particular liability balance. What amount would be subject to the
year, may claim penalty for the underpayment of estimated taxes?
a. Such excess as either a credit or an itemized deduction, a. $0.
at the election of the employee, if that excess, resulted b. $200.
from correct withholding by two or more employers. c. $500.
b. Reimbursement of such excess from his employers, if d. $16.500.
that excess resulted from correct withholding by two or
more employers. AC
c. The excess as a credit against income tax, if that excess 28. Jim and Mary are married and file a joint return
resulted from correct withholding by two or more for 1999. They have one child, Jennifer, who is 7
employers. years old. Assuming their modified AGI for 1999 is
d. The excess as a credit against income tax, if that excess $112.100, calculate their Child Tax Credit.
was withheld by one employer. a. $250.
b. $350.
c. $400.
d. $500.
 AC
29. Bob and Carol are married and file a joint return for
1999. During 1999, they paid $5.500 in qualified
adoption expenses for their new son Joshua. The
amount of the adoption credit for the year is:
a. $0
b. $5.000
c. $5.500
d. $6.000

AC
30. Bill is a single and has modified AGI of $44.000 for
1999. Bill paid $4.000 in tuition for his daughter Kate
to attend State University in her freshman year.
Determine the amount of Bill's HOPE scholarship credit
for the year.
a. $600.
b. $900.
c. $1.500.
d. $4.000.

AC
31. Steve is single and has modified AGI of $44.000 for
1999. Steve paid $6.000 in tuition for his daughter Sue
to attend State University in her senior year. Determine
the amount of Steve's HOPE credit for the year.
a. $0.
b. $600.
c. $1.500.
d. $6.000.

AC
32. Tom is 45 years old and has a dependent daughter
Denis. During 1999, Tom took three premature
distributions from his IRA account. The first
distribution was $6.000 and was used as a down-
payment on his first home. The second distribution was
$10.000 and was used to pay off his credit card
balances. The third distribution was $8.000 and was
used to pay for tuition for his daughter Denis who is
attending State University. Tom will be subject to a
10% penalty tax on the early withdrawals of:
a. $-0-
b. $1.000
c. $1.600
d. $2.400