Individual taxation: filing season update.

• Author: Cook, Ellen D.

EXECUTIVE SUMMARY

* A number of credits and other items that were scheduled to expire (or had already expired) were extended by the Tax Extenders Act. The act also increased the alternative minimum tax (AMT) exemption amount and made changes to the rules regarding the AMT minimum tax credit.

* The Housing Assistance Tax Act provided various credits and deductions for homeowners, including a refundable credit for first-time homebuyers. The Heroes Earnings Assistance and Relief Act provided benefits for members of the military and the intelligence community.

* Numerous changes affecting individuals were made in regulations and other guidance issued by the IRS, as well as in decisions by the Tax Court and other federal courts.

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This article covers recent significant developments affecting taxation of individuals, including cases, regulations, and legislative changes, and important information for the upcoming filing season. The items are arranged in Code section order.

Sec. 1: Tax Imposed

Kiddie tax: Under the kiddie tax, minor children's unearned income is taxed at their parents' highest rate. (1) The kiddie tax has been expanded for 2008. For 2007, it applied to the unearned income of children under age 18. It now applies to investment income of children under age 19 and certain children under age 24. Specifically, the kiddie tax now applies to a child aged 19-23 if:

1. The child is a full-time student before the close of the tax year; and

2. The child's earned income does not exceed one-half of his or her support. For tax years beginning in 2008, the minimum basic standard deduction amount used to reduce the net unearned income reported on the child's return that is subject to the kiddie tax is $900. (2) The same $900 amount is also used to determine whether a parent may elect to include a child's gross income in the parent's gross income and to calculate the kiddie tax. (3)

   Capital gains: Taxpayers in the 15 % or lower tax brackets have a 0% capital gains rate for tax years beginning after 2007 and before 2011. (4)

   Sec. 23: Adoption Expenses

   The Fostering Connections to Success and Increasing Adoptions Act (5) includes a provision that requires states to inform any individual who is adopting (or who the state is made aware is considering adopting) a child who is in foster care under the responsibility of the state of the potential eligibility of the individual for the Sec. 23 adoption credit.

   For 2008, the credit allowed for the adoption of a child with special needs is $11,650; (6) the maximum credit allowed for other adoptions is the amount of qualified adoption expenses up to $11,650. (7) The available adoption credit phases out for taxpayers with modified adjusted gross income (AGI) between $174,730 and $214,730.

   Sec. 24: Child Tan Credit

   The Tax Extenders Act (part of the Emergency Economic Stabilization Act) (8) makes the Sec. 24 child tax credit refundable to the extent of 15 % of the taxpayer's earned income in excess of $8,500 (lowered from $12,050 for 2008 only). The phaseout of the credit is unaffected.

   Sec. 25A: Hope and Lifetime Learning Credits

   For tax years beginning in 2008, a taxpayer's modified AGI in excess of $48,000 ($96,000 for a joint return) is used to determine the reduction in the amount of the Hope scholarship and lifetime learning credits otherwise allowable. (9)

   Sec. 25D: Residential Energy-Efficient Property Credit

   The Sec. 25D(g) residential energy-efficient property credit for qualified solar and fuel cell property expenditures has been extended for eight years, through 2016. In addition, a taxpayer may now claim the residential energy-efficient property credit against the alternative minimum tax (AMT).

   Sec. 26: Limitation Based on Tax Liability

   The Tax Extenders Act provides that under Sec. 26(a)(2) the nonrefundable personal credits may offset the AMT.

   Sec. 32: Earned Income Credit

   For 2008, the AGI limits for the earned income credit increase. For single taxpayers who had one child living with them, the threshold phaseout amount is $15,740 ($18,740 if married filing jointly) and the completed phaseout amount is $33,995 ($36,995 if married filing jointly). For single taxpayers who had two or more children living with them, the threshold phaseout amount is $15,740 ($18,740 if married filing jointly) and the completed phaseout amount is $38,646 ($41,646 if married filing jointly). For single taxpayers with no child living with them the threshold phaseout amount is $7,160 ($10,160 if married filing jointly) and the completed phaseout amount is $12,880 ($15,880 if married filing jointly). (10)

   The maximum investment income a taxpayer can have and still get the credit has increased to $2,950. (11)

   Effective for tax years ending after December 31, 2007, the Heroes Earnings Assistance and Relief Act of 2008 (12) makes permanent the election first introduced by the Working Families Tax Relief Act of 2004 (13) to treat tax-free combat pay as earned income for purposes of the earned income tax credit. (14)

   Sec. 36: First-Time Homebuyer Credit

   Introduced by the Housing Assistance Tax Act of 2008, (15) new Sec. 36 grants a refundable first-time homebuyer's credit to eligible taxpayers. The credit, computed as the lesser of $7,500 ($3,750 for married taxpayers filing separately) or 10% of the purchase price of the home, applies to principal residence purchases made after April 8, 2008, and before July 1, 2009. Phased out for taxpayers with modified AGI income in excess of $75,000 ($150,000 for married taxpayers filing jointly), the credit must be claimed on 2008 tax returns and must be recaptured over a 15-year period starting in the second year following the year of purchase. The taxpayer claims the credit on new Form 5405, First-Time Homebuyer Credit.

   To be eligible, a taxpayer must be a first-time homebuyer, defined as someone who has not had a present ownership interest in a principal residence during the three-year period ending on the date the principal residence is purchased. (16) Also, the taxpayer must not have purchased the residence from a related party.

   The residence purchased must be in the United States and must be purchased between April 8, 2008, and July 1, 2009. However, taxpayers who purchase a residence in 2009 (before July 1) may elect to treat the purchase as having taken place on December 31, 2008, for purposes of the credit.

   Unmarried individuals may jointly purchase a residence and allocate the $7,500 credit between them. (17)

   The IRS has issued IR-2008-106, which includes questions and answers that elaborate on which home purchases qualify, who cannot take the credit, and how and when the credit should be repaid.

   Sec. 53: Credit for Prior Year Minimum Tax Liability

   The Tax Extenders Act increases the AMT refundable credit amount for individuals with long-term unused minimum tax credits to 50%. (18) It increases the refundable credit by 50% of interest and penalties that were paid by the taxpayer before October 3, 2008. It also allows an abatement of any underpayment of tax, interest, and penalties for tax years ending before January 1, 2008, attributable to incentive stock options (ISOs) due and unpaid as of October 3, 2008. (19)

   Sec. 55: Alternative Minimum Tax

   The Tax Extenders Act increases the AMT exemptions for 2008 to $69,950 in the case of a joint return and $46,200 for single taxpayers. (20) Commonly referred to as the "AMT patch," this change will provide AMT relief to an estimated 18.4 million taxpayers and cost an estimated $60 billion.

   The act also allows taxpayers to offset nonrefundable personal tax credits against AMT for 2008 (21) and allows five-year modified accelerated cost recovery system life for farm machinery for both regular tax and AMT for 2009 only. (22)

   The Housing Assistance Tax Act allows taxpayers to offset low-income housing credits and housing rehabilitation credits against the AMT (23) to (in the words of the Senate Finance Committee staff summary of the act) "eliminate costs imposed on housing programs by the alternative minimum tax."

   In a Tax Court decision, a taxpayer's invention of a side calculation for qualifying dividends to limit the tax rate to 15% and avoid a higher effective rate as a result of AMT was not allowed. (24)

   Sec. 56: Adjustments in Computing AMT

   The Emergency Economic Stabilization Act allows 100% of net operating losses attributable to federally declared disaster areas in addition to the AMT net operating loss (NOL) for tax years beginning after December 31, 2007. The act also allows an AMT deduction for expenses to remediate a "qualified contamination site" per Sec. 198 (commonly known as "brownfield" remediation costs).

   Case law: In 2000, a taxpayer exercised ISOs, some of which related to shares that were not vested. He made a Sec. 83(b) election to report AMT income for the nonvested shares, and he owed the AMT for 2000. In 2001, he lost his job and forfeited his nonvested shares; an AMT capital loss of $680,000 resulted. In 2002, the taxpayer sold his vested shares for a regular tax capital gain of $60,000 and an AMT capital loss of over $2.5 million. He deducted these losses for AMT purposes as net operating losses. The Ninth Circuit denied NOL treatment for AMT, (25) as had the Fifth Circuit in 2007. (26)

   Norman (27) and Palahnuk (28) involve nearly the same facts, except that these taxpayers did not have nonvested shares. The courts denied NOL treatment for AMT in these cases also. Palahnuk concludes that unless explicitly stated otherwise, all provisions that apply in calculating regular income tax also apply in calculating AMT. In 2008, the Federal Circuit reached the same conclusion. (29)

   Sec. 57: Items of Tax Preference

   Under the Housing Assistance Tax Act, interest on certain tax exempt housing bonds will not be subject to AMT for housing bonds issued after July 30, 2008. (30)

   Sec. 62: Adjusted Gross Income

   Sec. 62(a)(2)(D) allows eligible...