SINGLE WITH DEPENDENTS

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2 Hour(s) - Other Federal Tax

IRS Provider #: UBWMFIRS Course #: UBWMF-T-00209-21-S

NASBA: 116347

CTEC Provider #: 6209CTEC Course #: 6209-CE-0031

The information provided in this publication is for educational purposes only, and does not necessarily reflect all laws, rules, or regulations for the tax year covered. This publication is designed to provide accurate and authoritative information concerning the subject matter covered, but it is sold with the understanding that the publisher is not engaged in rendering legal, accounting or other professional services. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

To the extent any advice relating to a Federal tax issue is contained in this communication, it was not written or intended to be used, and cannot be used, for the purpose of (a) avoiding any tax related penalties that may be imposed on you or any other person under the Internal Revenue Code, or (b) promoting, marketing or recommending to another person any transaction or matter addressed in this communication.

COURSE OVERVIEW.............................................................................................................................................................. 7

Course Description.......................................................................................................................................................................... 7

Learning Objectives......................................................................................................................................................................... 7

SINGLE - WITH DEPENDENTS .............................................................................................................................................. 7

Children and Tax Returns............................................................................................................................................................... 7

Reporting Tip Income...................................................................................................................................................................... 9

Earned Income Credit Eligibility ..................................................................................................................................................11

EITC Due Diligence ........................................................................................................................................................................13

EITC - Credit vs. Refund ................................................................................................................................................................14

Other Child Related Credits .........................................................................................................................................................15

Saving for Retirement ...................................................................................................................................................................16

Federally Declared Disaster Relief ..............................................................................................................................................18

Who are the Kids Dependents of? ..............................................................................................................................................19

CASE STUDIES..................................................................................................................................................................... 21

Tip Income......................................................................................................................................................................................21

EITC..................................................................................................................................................................................................22

APPENDIX A ....................................................................................................................................................................... 23

Tip Income......................................................................................................................................................................................23

APPENDIX B........................................................................................................................................................................ 25

Earned Income Tax Credit (Refundable) ....................................................................................................................................25

APPENDIX C........................................................................................................................................................................ 29

Child and Dependent Care Credit (Non-refundable) ...............................................................................................................29

Child Tax Credit..............................................................................................................................................................................31

Saver's Credit (Non-refundable)..................................................................................................................................................33

APPENDIX D ....................................................................................................................................................................... 34

Federal Declared Disaster Area...................................................................................................................................................34

APPENDIX E........................................................................................................................................................................ 34

Items Excluded from Gross Income ...........................................................................................................................................34

Course Description 7

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COURSE OVERVIEW

COURSE DESCRIPTIONIn this illustrative course, the goal is to address the various credits available to single parents. In addition to the child tax credit and the child care credits, many single parents qualify for the earned income tax credit. This credit is not only available to taxpayers with children, and this course strives to review the key determining factors in evaluating a taxpayer for qualification. Entitlement for dependency allowances, the dependency rules, and determining who the child is a dependent of. Unreported social security and Medicare is also addressed, particularly as it relates to the receipt of tip income.

LEARNING OBJECTIVESDetermine applicable credits (e.g., earned income tax credit, child tax credit, education, retirement savings, and dependent child care credit).

Determine special filing requirements (e.g., presidentially declared disaster areas).

Determine qualifying child/relative tests for Earned Income Credit.

Earned Income Tax Credit (EITC) (e.g., Schedule EIC Earned Income Credit, Form 8867 Paid Preparer’s Earned Income Credit Checklist).

Unreported Social Security and Medicare tax – (e.g., Form 4137 Social Security and Medicare Tax on Unreported Tip Income).

Appropriate use of Form 8867 Paid Preparer’s Earned Income Credit Checklist and related penalty for failure to exercise due diligence (e.g., IRC 6695(g)).

SINGLE - WITH DEPENDENTS

CHILDREN AND TAX RETURNS"Stop it, Samuel!" the young woman screams at the top of her lungs. Samuel, however, is too consumed with chewing the pencils taken from your desk to hear the admonitions of his mother. "Sarah keeps hitting me!" shrieks a young plaintiff at a decibel level sufficient to penetrate the cacophony of crying, whining, and screeching that has enveloped your office. The beleaguered young mother mouths something to you as she retrieves an infant from the floor, but the sound capacity of the room has been filled with screams of "mamma," "stop it!" "you stop it!" "mommy," "noooo," "I'm sweating," "mamma," "look what I found," "noooo," "give it back!" "mommy" and other unidentifiable complaints, observations, and nondescript clatter.

8 Single - with Dependents

"I am soooo sorry," the young woman shouts, grabbing the pencils away from Samuel while balancing the baby on her hip with her other arm. "She keeps hitting me," a sibling of Samuel shouts while tugging on her mother's pants. "Sit down NOW!" is the retort, delivered in a tone designed to both instill fear and impose order. The command achieves half of its objective as four frightened gremlins engage in a life-or-death struggle to obtain what appears to be the one and only desirable spot on your office sofa.

Eventually, the four couch contestants manage a provisional truce and the rumpus considerably subsides, only intermittently erupting into flare-ups as one or more of the combatants is suddenly overwhelmed by the ignominy of having to occupy their present position. The resulting shoves, slaps, and kicks prompt a salvo of searing looks and threatening gestures from the woman that, each time, succeeds in temporarily quieting the melee.

The infant being held by the woman, who has taken a seat opposite your desk, is now seemingly content to salivate on some sort of stuffed lion that bears the scars of multiple ferocious bites. "I am soooo sorry," the woman repeats contritely. "They are usually pretty good," she says, snapping her fingers in the direction of the sofa to stem a simmering skirmish.

Remarkably, Sue Ann Schmidt seems none the worse for wear. Barely 30 years old, she has somehow managed to keep track of five children, including baby Sean, while holding down a waitressing job at a local Denny's. Her husband left the home several years ago, reappearing for a brief liaison that did not result in reconciliation, but did result in Sean. The older siblings, Samuel (age 6), Sarah (age 5), and twins Shane and Sophie (age 4) have learned to recognize when their mother means business, and have now calmed down considerably.

"It's good to see you, Sue Ann. Thanks for coming by. I'll try to make this quick - I see you have your hands full," you say.

"Ain't that the truth," she says in her country twang. "At least we're all healthy this year. Remember last year when I came to see you? It turned out Sarah had the chickenpox and before you knew it, they all got 'em. Are you feeling better now? I can't believe you had never had them."

Reporting Tip Income 9

REPORTING TIP INCOME"Yes, I'm fully recovered now," you respond, not happy to be reminded of the six weeks of pain and itching you endured. "Did you do your tip reporting this year as I explained to you?"

Despite the fact that Sue Ann manages a chaotic household during the day and a full-time job at night, she has never mastered the intricacies of reporting her tip income.

"Here's my list," she says, handing you a sheaf of torn-out notebook pages listing each day she worked and the amount of tips collected.

You have successfully impressed upon her that she is required to keep a daily record of her tip income or some other reliable documentary evidence, and at least she does that much.

"As I've told you, Sue Ann, failing to report your tips means you have to pay a penalty of 50% of your share of FICA on the amount you failed to report, plus the tax on the tips themselves," you say once again to her, trying not to lecture.

"What is FICA, anyway, other than a pretty name?" she asks.

"A pretty name?"

"Yeah, my cousin Fiona named her little girl Fica. I think she got the idea from hearing me say how you are always telling me about it."

"FICA stands for 'Federal Insurance Contribution Act,'" you explain to her. "It's the law that requires the payment of Social Security and Medicare tax on wages. Tips received by you in any month in which the amount of tips you receive equals $20 or more are considered wages and FICA applies to them."

"What difference does it make, as long as I report all my tips on my tax return? Why do I have to report them to my employer too?" Sean wails loudly, as if in agreement.

"Your employer has to know the amount of tips you received because your employer is the one who is supposed to withhold and pay the FICA. When that doesn't happen you get hit with the penalty."

"One year you got me out of the penalty, can't we do that again?"

"That was the year you had the twins and Steve left you. Steve had handled all of the financial and tax matters and, on top of that, it was your first year waitressing. Remember, you had only worked for a couple of months, and your boss was out of town for most of that time and did not inform you of the requirements. The penalty does not apply in circumstances like that where we can show that the failure was due to reasonable cause and not due to willful neglect. Once you know about the requirement, however, we no longer have that excuse."

Despite the bad news, Sean seems now to be delighted and he lets out a big laugh, followed by what you hope is gas, but could be more.


[Included for comedic value - authenticity not verified. We do not suggest trying this excuse]

"So what do we have to do?" she asks.

"Just like last year, we'll have to calculate the Social Security and Medicare tax on Form 4137 and attach it to your return," you tell her.

Earned Income Credit Eligibility 11

Just at that moment an unidentified occupant of the sofa has been poked, pinched, or shoved one time too many, resulting in a bloodcurdling yell and the outbreak of hostilities. Sue Ann instinctively hands the baby to you to attend to the maelstrom, at which point you realize that protective padding on his bottom is more than just Pampers.

Samuel is yanked from his perch and sentenced to serve time sitting next to his mother, putting the front of your desk within easy range of his feet. You start to hand baby Sean back to his mother but are unable to do so before he deposits a puddle of milky-white digestive enzymes on your shoulder. "Uh-oh," Sue Ann responds, handing you a small towel from her diaper bag. "That happens all the time—you need to drape a towel on your shoulder when you hold him," she instructs as if that had been an option.

EARNED INCOME CREDIT ELIGIBILITY"That's OK, just a little accident. Let's get back to your return. It looks like your income level will make you eligible for the Earned Income Tax Credit this year."

Fortunately, you took a CPE course about the Earned Income Tax Credit, or "EITC," before filing season. You remember being somewhat surprised to learn that the EITC doesn't really have anything to do with taxes, but is rather a social welfare program administered by the IRS. The instructor explained how it was designed by Congress in part to offset the burden of Social Security taxes and to provide an incentive to work. Taxpayers who are eligible for the benefit first apply it against any tax liability they have, and any remaining amount is refunded to them.

"I need to go potty mommy!" cries one of the twins. "Me too!" shouts the other, which prompts a volley of "do not," "do so," followed by another round of pushing and poking. "OK, I need to change the baby anyway," Sue Ann observes much too late. "You two stay here," she says to Samuel and Sarah. "I'll be right back," she threatens, gathering up the diaper bag, baby, and twins.


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Samuel shoots a mischievous grin as Sarah pouts from her position across the room. You decide that this would be a good time to review the outline from the CPE course you took on the EITC before filing season.

Pulling the materials out of your desk drawer, you recall that the first EITC eligibility requirement is that the taxpayer must have earned income. Wages and earnings from self-employment count, so Sue Ann meets this requirement.

You open the materials to the list of requirements and review the remaining criteria to make sure Sue Ann qualifies.

Number 2: The taxpayer and any qualifying child must have a valid Social Security number. No problem there. Even baby Sean has a Social Security number since they now issue them right after birth. You remember how you once had a client who was not eligible for the EITC because all they had was an Individual Taxpayer Identification Numbers, or "ITIN." Another client was in the process of adopting and only had an Adoption Taxpayer Identification Number for the child. You remember that they had to file an amended return after the adoption was final and the child had a valid Social Security number to get the EITC.

The American Rescue Plan Act of 2021 established several changes to the Earned Income Credit. One of the changes to the EITC for 2021 and future years include a taxpayer is eligible for childless earned income credit in case of qualifying children who fail to meet certain identification requirements—if a qualifying child does not have a valid SSN, the taxpayer may claim the earned income tax credit for individuals with no qualifying children.

Number 3: The taxpayer cannot use the "married filing separate" filing status, generally. However, under the American Rescue Plan Act of 2021, for 2021 and future years, EITC allowed in case of certain separated spouses—special rule for a separated spouse. Sue Ann is still legally married to Steve. However, she is treated as being "unmarried" for tax purposes because she furnished over half of the cost of maintaining a household for more than half the year that was the principal place of abode of at least one dependent child, and her spouse wasn't a member of that household at any time during the last six months of the year. Since she is treated as being unmarried, is not a surviving spouse, and is not a nonresident alien, she qualifies for head of household filing status.

She could, of course still file jointly with Steve because they are still legally married, but from what you know about their relationship, you have advised her not to do that. Each person who files a married filing joint return is fully liable for all the tax associated with that return, even if the tax is a result of the other spouse's activities. Although so-called "innocent spouse relief" may be available under Code section 6015, it can be difficult to obtain and is never a "slam dunk." Steve used to prepare the couple's tax returns, and you are aware that he made several errors, and may even have omitted some of his income. As a result, you do not think it would be a good idea for Sue Ann to file jointly, and she has taken your advice.

Another one of the changes to the EITC for 2021 and future years under the American Rescue Plan Act of 2021include EITC allowed in case of certain separated spouses. Special rule for a separated spouse – An individual shall not be treated as married if such individual:

is married and does not file a joint return for the taxable year,

resides with a qualifying child of the individual for more than one-half of such taxable year, and

during the last 6 months of such taxable year, does not have the same principal place of abode as the individual’s spouse, or

has a decree, instrument, or agreement (other than a decree of divorce) with respect to the individual’s spouse and is not a member of the same household with the individual’s spouse by the end of the taxable year

Number 4: The taxpayer must be: (1) a U.S. citizen or (2) a resident alien all year or (3) a nonresident alien married to a U.S. citizen or resident alien and choose to file a joint return and be treated as a resident alien. That reminds you of a

EITC Due Diligence 13

recent call from a colleague who was confused about resident alien status. You explained to her that a non-U.S. citizen is a resident alien if they either have a green card or meet the substantial presence test. The substantial presence test, you explained, means that they were physically present in the U.S. for at least 31 days during the current year or 183 days over a three-year period, counting only 1/3 and 1/6 of the days present in the prior two years, respectively.

Number 5: The taxpayer claiming the EITC—in this case, Sue Ann—can not be a qualifying child of another person. You quickly flip to the section of the outline that discusses "qualifying child" status. It tells you that a qualifying child must meet four tests: (1) the relationship test, (2) the age test, (3) the residency test, and (4) the joint return test. The relationship test simply requires that the individual be related as a natural, adopted, foster, or step-child, or a sibling, step-sibling, or descendant of any of those relations. Sue Ann's parents are still alive, and she has two siblings and several aunts and uncles, so she could potentially be the qualifying child of any of them. However, Sue Ann is not under age 19 nor under age 24 and a full-time student, so she would fail the second. Furthermore, you know that Sue Ann did not live with any relatives for more than half the year and she is not filing a joint return, so she fails the last two tests as well and is clearly not another person's qualifying child.

Number 6: The taxpayer cannot file Form 2555, Foreign Earned Income. You remember Sue Ann telling you that she has never even been out of the state, much less the country, so you're confident she meets this requirement.

Number 7: The taxpayer cannot have investment income over a certain amount, which is $10,000 or less for 2021, but changes annually for inflation. Being a single parent with five kids, Sue Ann has only a modest amount in education and retirement savings, so you know there is no danger of her failing to meet this requirement.

Another change to the EITC for 2021 and future years under the American Rescue Plan Act of 2021 includes an increase in investment income limit—investment income must be $10,000 or less for 2021 (up from $3,650), and taxable years beginning after 2021 shall be increased for inflation.

Number 8: The taxpayer must have earned income below a specific threshold, depending on their filing status. The earned income threshold varies depending on whether the taxpayer has no qualifying children or one, two, or three or more qualifying children. Since Sue Ann has three or more qualifying children, the highest earned income threshold will apply.

EITC DUE DILIGENCEYou preliminarily conclude that Sue Ann is eligible for the EITC, and you begin to document your compliance with the due diligence requirements. You remember learning in CPE class that preparers are subject to a $545 per return penalty for returns filed in 2022 (generally 2021 tax returns filed in 2022) if they do not comply with the EITC due diligence requirements, so you turn to the part of the CPE materials that discusses the three components of EITC due diligence and review them.

First, you must complete Form 8867 Paid Preparer's Earned Income Credit Checklist and attach it to the return.

Second, you must either complete the Earned Income Credit Worksheet in the Form 1040 instructions or otherwise record the EITC computation in your work papers, including the method and information used to make the computation.

Finally, you must not know or have reason to know, that any information you used to determine the EITC is incorrect. Along these lines, you remember the instructor's emphasis on the fact that you may not ignore the implications of information you receive and must make reasonable inquiries if the information appears to be incorrect, inconsistent, or incomplete in any way. You remember the admonition the CPE instructor gave: "Always, always, always contemporaneously document in the files the reasonable inquiries you made and the responses to these inquiries."

Looking up from the CPE materials as you complete your review, you notice that Sarah has found a pen with which to scribble on your magazines and Samuel has once again taken to chewing pencils. Just then Sue Ann returns. "Samuel, I


said stop!" she shouts grabbing the prey from his jaws with such force you fear a bicuspid or two may come with it. Forcefully placing the twins next to their sister on the sofa with her one free arm she settles back in for another round. "How are we doing?"

"Good," you say. "I need to confirm a few things with you. With that, you pull out a Form 8867 Paid Preparer's Earned Income Credit Checklist and begin going over it with Sue Ann to confirm the facts as you understand them.

Once you've gone through all of the information you tell her, "Well, it looks like you qualify for the Earned Income Credit."

EITC - CREDIT VS. REFUND"Is that good?" she asks.

"Very good, especially because it is a refundable credit."

"What does that mean?"

"Tax credits all reduce the amount of tax you pay, dollar for dollar. Just like the name implies, they represent 'credits' against your tax liability. But most tax credits are limited to the amount of tax you owe; credits exceeding your tax liability are wasted."

"But not the Earned Income Credit?" she inquires.

Other Child Related Credits 15

"No. Some credits like the EITC, the Child Tax Credit (the Additional Child Tax Credit is the part that is refundable), and the American Opportunity Credit are refundable in whole or in part. That means that to the extent the EITC is more than your tax liability, the IRS will send you a check for the difference."

"Oh, yeah," she says. "I have a friend who used to get that, but I think she got it during the year, with each paycheck."

"There used to be a program allowing for what was called the 'advanced EITC,'" you acknowledge. "Under that program, you could get your EITC a little at a time in your paycheck rather than waiting to get it all at once when you file your return. Congress eliminated that program for years after 2010, though."

OTHER CHILD RELATED CREDITS"Huh," she responds, bouncing baby Sean on her knee as you keep a watchful eye for any projectile emissions. "Can I get any of those other credits?"

"Oh yeah, there are a bunch of credits that you may be eligible for. For example, there is the Child and Dependent Care Credit. This credit is based on expenses you incur for the care of a dependent under the age of 13 that make it possible for you to work or to seek employment."

"But I work nights, so I pay for a sitter during the day, while I'm at home sleeping. My boyfriend Stanley is home with them at night."

"That's OK," you tell her. "The babysitting costs are deemed to enable you to work even if you pay someone to watch the kids while you are at home sleeping, as long as the other parent is working or otherwise not available."

"Steve wasn't available even when we lived together," she laments, rolling her eyes. "But there may be another problem. My mother is the person that I pay to watch them. Does that still count?"

"That's OK, too. You can make the care payments to anyone that you cannot claim as a dependent and who is not your spouse or a parent of the child."

"What about the cost of the preschool program for the twins and the summer camp I sent Samuel to?"

"We can count any expenses related to sending a child to an educational program below the first grade, like nursery and preschool programs. We can't take into account the cost of transporting the child from your home to the care location and back or the cost of sending the child to overnight camp. Also, expenses related to food, clothing, and entertainment don't count unless they are incidental to the cost of care."

"How much of a credit do I get?" she asks, as Samuel manages to tip his chair over. "I'm dead, I'm dead!" he yells.

Taking your cue from Sue Ann, you ignore the declared fatality and respond as if it were just the two of you in the room.

"First, we determine the actual expense. Regardless of how much you paid, the child and dependent care expenses we take into account cannot be more than $3,000 for one child and $6,000 for two or more. Of course, the total expenses claimed cannot exceed your earned income; since you earned more than $6,000 that is not an issue. The credit itself is equal to 35% of the child or dependent care expenses."

"So the credit is 35% of $6,000 because I paid my mom to watch more than two children?"

"No, not necessarily. The 35% rate may be reduced to as low as 20%. It goes down by 1% for each $2,000 your adjusted gross income exceeds $15,000, but not below 20%. Also, the expenses claimed must be reduced by any dependent care benefits you received from your employer."

"I don't think I get any benefits like that from work, but I'm not very good at keeping track of these things," she tells you.


"We can check your W-2," you say reassuringly, picking up the document she previously provided to you. "If there had been any employer-provided dependent care benefits they would have been reported in box 10. We'll go ahead and claim the credit by completing Form 2441 and attaching it to your Form 1040."

You go on by explaining that there is also something called a "Child Tax Credit." "This is a credit of $2,000 for each qualifying child under the age of 17 that lived with you for more than half the year."

"I guess the baby won't count then, since he was born in September," she says, as you note with substantial relief that baby Sean and three of his siblings have fallen asleep. Only Sophie remains conscious, reconnoitering around your office floor in what appears to be a search for edibles.

"Actually, a child who was born or died during the year is considered to have lived with you for the requisite period. Even temporary absences for things like medical care, military service, or detention in a juvenile facility, count as time lived with you."

"None of them have been in the military or in juvie yet," she says with a laugh.

"Thank goodness for that," you say, thinking to yourself that it won't be long.

"Is this Child Tax Credit refundable, like the EITC?" she asks.

"Well, sort of," you explain. "The credit is refundable, but generally only to the extent of the 15% of your earned income above $2,500, up to $1,400. There is a special rule for people like you who have three or more qualifying children. In that case, the refundable amount is actually the larger of: (1) 15% of your earned income above $2,500 or (2) the amount by which your Social Security tax exceeds the EITC. Sometimes the refundable portion of the Child Tax Credit is referred to as the 'Additional Child Tax Credit.' We'll determine the Child Tax Credit and the refundable portion by completing Form 8812 and attaching it to your return."

"Alright, I'll let you figure that out. Are there any other credits that I can take?" she asks.

SAVING FOR RETIREMENT"It looks like you made an IRA contribution. That means you may be eligible for the Retirement Savings Contribution Credit. The amount of this credit is a percentage of your contribution to an IRA or qualified retirement plan based on your filing status and modified adjusted gross income. The maximum amount of credit is 50% of the first $2,000 of eligible contributions, so the maximum amount for someone filing single or head of household like you would be $1,000. No part of this credit is refundable, and the amount phases out as your income goes up."

Going over your mental checklist of other credits, you begin to think that just about covers it. "Did you take any college or vocational courses last year?" She shakes her head. Since her kids are too young to take advantage of the American Opportunity or Lifetime Learning Credits, you know that the education credits are out. Sue Ann is well under 65 and not disabled, so she is not eligible for the Elderly or Disabled Credit, and you know she did not pay any taxes to another country, so the Foreign Income Tax Credit doesn't apply.

Did you make any improvements to your home or buy any energy-efficient appliances last year?" you ask.

"Yes," she says. "We were getting a draft through some of the windows, so daddy helped me cover them with plastic, and I bought one of them new flat screen T.V.s."

Saving for Retirement 17

Nodding your head understandingly, you advise her that those expenses won't count. "There are two nonrefundable Residential Energy Credits," you explain. "The Nonbusiness Energy Property Credit is for physical improvements to the structure of the home itself. It covers things like energy-efficient insulation, roofing, hot-water heaters, and air conditioners. New energy-efficient doors and windows count, but just putting plastic over your existing windows won't cut it. The second credit, call the Residential Energy-Efficient Property Credit, is for investments in alternative energy, such as solar, wind, geothermal and fuel cells."

"We have a windmill out in front, but it's just for decoration," she says.

You smile and continue with your mental checklist. You recall that sometimes when people work two or more jobs they end up over-paying their FICA tax and are entitled to a refund of excess social security tax withheld, but because Sue Ann has only one job and did not even report all of her tips to her employer; you know that she will not have a refund of any excess social security tax.

"You didn't adopt any children last year, did you?" you facetiously ask with a smile.

Sue Ann laughs. "Are you kidding? Sometimes I'd like to put some of the ones I have up for adoption. You interested?"

Although you know she's kidding, you find that her question makes you throw up a little in your mouth. "No, that's OK," you say, waving your hand.


FEDERALLY DECLARED DISASTER RELIEFHaving exhausted your consideration of the basic tax credits that may be available, you glance over to the sleeping children on your sofa and notice that your furniture has become covered in mud—mud that was formerly covering their shoes. The sight of the muck reminds you of something. "You live down by the river, don't you Sue Ann? Didn't you get hit pretty badly by the flood last week?"

"You bet we did. We lost almost everything on the first floor. We had eighteen inches of water in the house. Samuel caught a trout in the living room. That's why I waited until the last minute to come see you. I'm still not sure I have found all the documents you need."

You recall hearing on the news that the county Sue Ann lives in was a federally declared disaster area. The law permits the IRS to grant taxpayers affected by a federally declared disaster additional time to file returns and pay taxes when the original or extended due date of the return falls within the disaster period. Also, taxpayers in a federally declared disaster area can more quickly obtain a refund by amending the previous year's return to claim losses related to the disaster.

"We may have more time because of the flood," you inform her. I'll check the IRS website for a listing of covered disaster areas and the specific tax relief provided if any.

"I think we've covered just about everything," you say. With the Earned Income Tax Credit, the Child Tax Credit and Additional Child Tax Credit, and the Retirement Savings Credit, you'll be in pretty good shape, despite the fact that you have to pay extra taxes and penalties for not reporting your tip income to your employer."

Who are the Kids Dependents of? 19

With that, you go to the IRS website, pull up Publication 1244, Employee's Daily Record of Tips and Report to Employer, print it out, and hand it to Sue Ann. "This Publication contains Form 4070, which you should fill out every month and give to your employer. It also has Form 4070A, which is a handy mechanism for keeping track of your tips. You don't have to use Form 4070A, but it might be more convenient than your scraps of notebook paper. I'll make twelve copies for you so you have one for each month."

WHO ARE THE KIDS DEPENDENTS OF?"Thanks a million, Robbie. There's just one other thing," she says. "I told my parents that they could take my dependency allowances for the twins. They're hoping for a refund this year, and I figured I should do alright with just three dependents."

You take a deep breath, preparing to give your usual dependency rule sermon, an exercise you are called upon to do several times each filing season. "The dependency allowance," you begin, "is not a fungible product that you can transfer to whomever you like. Your parents can only consider the twins as their dependents if the twins meet the criteria for being either qualifying children or qualifying relatives of your parents. When we went over the EITC checklist, you told me that all of the children lived with you for more than half the year."

"They did, but mom and dad lived with us for seven months, so technically the kids lived with my parents for over half the year too," she reveals.

"OK," you say, "but there are specific tie-breaking rules when a child is potentially the qualifying child of two or more taxpayers. If one of those taxpayers is the child's parent—that's you—then the parent wins the tie and the other taxpayers—in this case, your parents—can not claim the child."

"Really? That doesn't seem fair if I am willing to let them have the dependency allowances. How would the IRS find out?"

"That doesn't really matter," you tell her. "The application of the law doesn't depend on whether or not you think you might get away with breaking it."

"I guess you're right—I don't want to break the law. But I'm curious, what if Steven had lived with us for seven months? He's a parent too. What happens then?"

"When parents don't file a joint return, the child is treated as the qualifying child of the parent with whom the child resided for the longest period of time during the tax year," you explain to her. "If the child spent the same amount of time with both parents, the parent with the highest AGI gets to claim the child."

"But my friend Chelsea told me she was allowed to give her ex the dependency allowances for their kids, and I know Chelsea has a lot more income than her no-good ex-husband—he hasn't worked in years and can't even pay child support."

"That's another special rule," you tell her. "When a child's parents are divorced, legally separated, are separated under a written separation agreement, or live apart at all times during the last six months of the year, the custodial parent can release the dependency for the child by signing a written declaration on Form 8332. The child has to have been in the custody of one or both parents for over half the calendar year and the noncustodial parent has to attach the signed Form 8332 to their return. Although the deduction for exemptions is suspended for 2018 through 2025 by the Tax Cuts and Jobs Act, the eligibility to claim an exemption may make a taxpayer eligible for other tax benefits. The eligibility to claim an exemption for a child remains important for determining who may claim the child tax credit, the additional child tax credit, and the credit for other dependents, as well as other tax benefits."

"Oh yeah, I've heard something about that. I had another friend who was supposed to get the dependency allowances—it even said so in the court order granting their divorce. But the other parent wouldn't sign the form. I guess they could just attach the court order to their return."


"Actually, no. The noncustodial parent is not entitled to the dependency allowance unless they attach a signed Form 8332. In a case like that, their remedy is to get a contempt order from the divorce court and amend the return once the 8332 is signed."

"Get outta here!" she says with such loud surprise it wakes the baby and two of the other children. "That's just plain nuts."

"Maybe," you say, "but that's the way it is."

"I'm sure glad you deal with all this mess, I don't think I could take it," she says as she gathers multiple toys, a diaper, and one shoe from the floor. "Sophie, where is your other shoe?" she shouts. Sophie pleads the fifth as baby Sean starts wailing away and the Samuel-Shane death match begins anew.

"Thank you again," Sue Ann hurriedly states as she corrals her clan toward the door.

"No problem. I'll call you when the return is done," you advise. Sinking back into your chair as the drone of the wild slowly dissipates, you feel the tension begin to release from your body. For the moment you are left alone with your thoughts; or at least your thoughts, a stray shoe, and an aroma of undefined origin.

Tip Income 21

CASE STUDIES

TIP INCOMEMONKICHI ITO V. COMMISSIONER, TC SUMM. OP. 2008-38 (APRIL 16, 2008)

FACTS:

Mark Monkichi Ito worked as a bartender in the lobby lounge at the Grand America Hotel, an opulent establishment in Salt Lake City. As luck would have it, the IRS conducted both an employment tax audit of the hotel and an income tax audit of Mark. To determine the accuracy of the tip income being reported, the IRS used the tip income documented credit card sales at the food and beverage locations in the Grand America Hotel, applying a discount to those amounts to calculate tips received on cash sales. That information was then used to calculate an employee per hour tip rate. Taking into consideration the number of hours Mark worked, the IRS determined that Mark had received tips well in excess of what he reported on his return, and therefore proposed a deficiency.

Mark did not keep appropriate records of his tip income and conceded that the amount of tips received was in excess of that reported on his return. He objected to the figure arrived at by the IRS, however, on the basis that bartenders in the lobby lounge routinely received substantially less in tips than the wait staff in the restaurant. In support of this contention, Mark pointed out that his hourly wage was set at an amount that was more than four times higher than members of the wait staff, ostensibly to make up for the anticipated difference in tips.

LAW:

Tip income received by a taxpayer constitutes compensation for services rendered and is includable in the taxpayer's gross income. Catalano v. Commissioner, 81 T.C. 8, 13 (1983), aff'd. without published opinion sub nom. Knoll v. Commissioner, 735 F.2d 1370 (9th Cir. 1984); Way v. Commissioner, T.C. Memo. 1990-590. In order to establish the amount of tip income, the taxpayer is required to maintain appropriate records reflecting the tips received. Treas. Reg. § 1.6001-1(a). If he or she fails to do so, the IRS may use any reasonable method to reconstruct the taxpayer's income. United States v. Fior D'Italia, Inc., 536 U.S. 238, 243 (2002); Mendelson v. Commissioner, 305 F.2d 519, 521-522 (7th Cir. 1962), aff'g. T.C. Memo. 1961-319.

A common technique used by the IRS is to estimate the aggregate tips received by all employees by determining the total amount of tips reported on credit card transactions and extrapolating that amount to the combined credit card and cash sales, using a discount to reflect the fact that the tip rate on cash sales is likely to be less than that on credit card sales. Once the aggregate amount is determined, each individual employee's pro-rata share is calculated based on the relative number of hours worked. This technique was first approved by the Tax Court in McQuatters v. Commissioner, T.C. Memo. 1973-240.

ANALYSIS:

Mark's argument makes logical sense. It seems reasonable to assume that dinner bills will generally be well in excess of bar tabs and that the servers in the restaurant would therefore receive larger tips. Likewise, it seems probable that this situation was a principal reason that the hotel paid higher hourly wages to the bar staff.

Logic and reason, however, are but little use to a taxpayer in Tax Court when there is a failure of proof. As pointed out above, the law required Mark to maintain contemporaneous records of his tips. He did not do so. Furthermore, at the trial, he called no witnesses and offered no documentation to corroborate his arguments. The court noted that this would not have been hard to do. Surely he could have presented a comparison of bar credit card charges to restaurant

22 Case Studies

credit card charges or other financial records demonstrating the difference in sales. He could have offered the testimony of management as to why they differentiated the hourly wages. He did none of this.

In all trials before the Tax Court, the burden of proof is on the taxpayer. Tax Ct. R. 142(a). Furthermore, the determination of tax liability by the IRS is presumptively correct, and the taxpayer must prove by a preponderance of the evidence that the IRS's determination is improper. Welch v. Helvering, 290 U.S. 111, 115 (1933); Tax Ct. R. 142(a).

Given that Mark offered virtually no evidence, the court had little choice but to sustain the IRS's determination. Not only that, the court upheld the imposition of an accuracy-related penalty due to negligence or disregard of rules or regulations under Code Section 6662(b)(1) because Mark failed to keep records and made no reasonable attempt to accurately report his tip income.

EITCSANTOS V. COMMISSIONER, TC SUMM. OP. 2011-108 (SEPTEMBER 12, 2011)

FACTS:

Ada Santos lived in Utah with her 30-year-old disabled adult son, Walter. Ada paid the mortgage, as well as the property taxes, homeowner's insurance premiums, and the gas and electric bills. She paid any costs associated with maintaining the home and bought all of the groceries for the two of them. Walter received both Social Security and Medicaid benefits.

Ada filed her tax return as head-of-household and claimed Walter as her dependent. Because of her low income, she also claimed the Earned Income Tax Credit ("EITC"), using Walter as a qualifying child to increase the amount of the credit. The IRS asserted that Walter was not Ada's "qualifying child" and therefore that she was not entitled to the EITC. The IRS based its determination on the fact that Ada had not been able to show the total amount of support received by Walter, and therefore could not prove that he hadn't provided more than half of his own support. Ada brought the case to the Tax Court on her own, without the aid of representation. In part, because it found Ada's testimony to be credible, the court ruled in her favor and allowed the EITC.

LAW:

The definition of "qualifying child" is an individual who, among: (1) is the natural or adopted descendant of the taxpayer; (2) has the same principal place of abode as the taxpayer for more than one-half of the taxable year; (3) is under 19, under 24 and a full-time student, or is disabled (4) has not provided over one-half of his or her own support for the taxable year; and (5) has not filed a joint return with his or her spouse, if any. IRC §152(c)(1). In the past, a parent had to provide over one-half of the total support for the child. The current rule, however, only requires that the child not provide more than one-half of his or her own support.

ANALYSIS:

In calculating the total cost of support, all sources of support are generally included. Treas. Regs. §1.152-1(a)(2)(i). "Support" for this purpose includes food, shelter, clothing, medical and dental care, education, and the like.

Although government benefits like Social Security and Medicaid are normally excluded from the taxable income of the recipient, the value of these may be included in "support." See Turecamo v. Commissioner, 554 F.2d 564, 569 (2d Cir. 1977), aff'g. 64 T.C. 720 (1975); Treas. Regs. §1.1521(a)(2)(ii). This is not necessarily the case, however. In exercising its judicial discretion, the Tax Court has on occasion refused to include the value of government benefits in the support calculation on the basis of fundamental fairness. "To require that Medicaid payments be included in the support equation," the court has stated, "means that those individuals whose parents are the neediest will be the least likely to

Tip Income 23

get a dependency exemption . . . [which] seems exceedingly unfair and contrary to the basic thrust of the Medicaid program itself." Archer v. Commissioner, 73 T.C. 963, 971 (1980).

Government benefits may be received by children, of course, for reasons other than the impoverishment of the parents. Social Security benefits, for example, maybe provided after one parent has died. What the court seems to be saying is that, when government benefits are being provided based on the family's need, they should not be included in the support calculation.

Medicaid is a needs-based healthcare program, and Walter was receiving those benefits due to the low-income level of the household. The court, therefore, concluded that it was appropriate to exclude those benefits from Walter's support for the purpose of determining Ada's entitlement to the dependency exemption.

The IRS nonetheless persisted in its argument that Walter's total support was unknown. Its rationale was that the proper measure of the housing, food, and clothing petitioner provided to Walter by Ada was the "value" of those items, not necessarily what Ada actually paid. Significantly, the court held that the inability to conclusively prove the total cost of support was not a bar to establishing qualifying child status. In support of its conclusion, the court cited a case decided under the old dependency exemption rules when a parent had to prove that they paid for more than half of the child's support (Stafford v. Commissioner, 46 T.C. 515, 517 (1966)).

Finding that Ada proved that she paid all of the costs of maintaining the home and that, disregarding his Medicaid benefits, Walter paid little of his own support, the court concluded that Ada met the support test to make Walter her qualifying child. As such, not only was she entitled to the dependency exemption but the head-of-household filing status and the EITC as well.

APPENDIX A

TIP INCOMEAll tips must be reported as income. When an employee receives tips of $20 or more in any month, they must report the income to their employers on Form 4070, Employee's Report of Tips to Employer, or on a similar statement. This report is due on the 10th day of the month after the month the tips are received. Employers must collect income tax, employee social security tax, and employee Medicare tax on tips reported by employees. The employer can collect these taxes from an employee’s wages or from other funds he or she makes available.

When a taxpayer fails to keep records, or maintains only incomplete or inadequate records of income, or when a taxpayer’s records are no longer available, the IRS may recompute the tips in any manner that clearly reflects income. The IRS has great latitude in adopting a suitable method for reconstructing the taxpayer’s income. The IRS’s method of recomputing income carries with it the presumption of correctness, and taxpayers have a heavy burden of proving that the method chosen by the IRS is wrong. Although the IRS prevails in most cases involving the recomputation of tip income, the Service met its match when it audited bartender Alan Sabolic.

Sabolic has been employed as a bartender for over 20 years and was working at the Zuri Lounge in the MGM Grand Hotel and Casino in Las Vegas when he was audited. He would serve drinks to customers who sat at the six stools at his bar and to those who walked up to the counter. In front of the stools were video poker machines. If a customer was sitting at a stool and actively gambling on the video poker machine, Sabolic would serve him or her a complimentary drink. In fact, most of the drinks Sabolic served were complimentary. He did not work with waitresses and did not fill their orders.

Whether a drink was provided complimentary or the customer paid for it, Sabolic entered the transaction into the MGM Grand’s point-of-sales system under his unique employee identification number. When he provided a customer with a complimentary drink, the point-of-sales system would internally record it with a price discounted from the usual retail price of a drink. The system also tracked the customer’s payment for the drinks purchased, including whether the purchase was made with a credit card or cash, and the amount of any tip paid by credit card or room charge.

24 Appendix A

During the years at issue, Sabolic opted not to participate in the GITCA program. He had previously participated in the program for over 20 years but later opted out of it because he felt that the automatic tip rate was too high given the economic conditions during that time. Since he opted out of the GITCA Program, Sabolic was required to self-report his cash tips to his employer and keep personal records of how much he received in tips each shift.

Sabolic had a set routine of how he recorded his tips at the end of each shift. The point-of-sales system would generate a receipt that stated how much he had earned in tips from credit cards and room charges. He would cash out his charged tips receipt daily. Cash tips were not internally controlled by MGM Grand’s system, and so he would personally keep track of his cash tips for each shift.

Sabolic would put any change from cash tips that he received in a glass jar. He would add together his cash tips and his charged tips and enter the total into the system when he punched out. He would tip the cashier any leftover change that he received. This amount would then be automatically reported to MGM Grand’s payroll department. He also kept daily a personal tip diary by recording the total on a slip of paper. His daily totals were recorded in whole numbers.

After he submitted his tip information to MGM Grand’s system, Sabolic would “tip out,” or give a portion of his tips to, the barback who had helped him that shift. He did not keep a contemporaneous log detailing how much he paid out to the barbacks, but generally gave the barbacks 10% to 20% of his total tips. On his tax return, Sabolic reduced the total tips that he received by approximately 10% to account for the tip outs to the barback at the end of each shift.

Upon audit, the IRS obtained Sabolic’s sales records from MGM Grand for the tax years at issue. From these records, the IRS extracted three figures for each year: (1) Sabolic’s total charged sales, which included both credit card and room charge sales; (2) his total noncharged sales, which included both drinks purchased at full price in cash and all complimentary drinks; and (3) his charged tips generated by the charged sales.

Using the ratio of charged sales to charged tips the IRS determined a “charge tip rate” for each tax year. To be conservative, the IRS then reduced the charge tip rate by 2% to arrive at the “noncharged tip rate” for each year. They then reduced Sabolic’s total noncharged sales by a “stiff” rate of 15%, representing the frequency with which customers did not leave any tip or “stiffed” Sabolic. The IRS then applied the corresponding noncharged tip rate to Sabolic’s adjusted noncharged sales for each year in order to arrive at his total noncharged tip income. They then added the total noncharged tip income to the total charged tip income to arrive at total tip income for each year. They then reduced the total tip income by 10% to account for the tip outs Sabolic gave to the barbacks at the end of each shift. Finally, from this reduced total tip income for each year, the IRS subtracted the amount of tip income that Sabolic had reported on his respective tax returns. After all of the adjustments and calculations, the IRS determined that Sabolic had underreported his tip income by approximately $20,000 for each year under audit.

Sabolic objected to the recomputation by the IRS, maintaining that he met his burden of documenting his tip income because he kept detailed, contemporaneous daily logs that were substantially accurate. But the IRS argued that his logs were inadequate for several reasons.

First, the IRS pointed to the fact that the logs were recorded in whole numbers as an indication that they could not possibly be accurate. Surely Sabolic was not tipped in exact dollar amounts. However, Sabolic testified that when he was tipped with change he would put the change in a glass jar to be mixed in with the other tips. When he would periodically cash out the change jar, he would give the change to the cashiers who cashed him out at the end of the shift. He also testified that when he cashed out daily his charged tips receipt, he would give the cashiers any change that was generated by those tips. The Tax Court found Sabolic’s explanation credible and did not find the logs inadequate merely because the amounts were recorded in whole numbers.

Second, the IRS argued that the daily tip logs were inadequate because Sabolic did not keep track of how much he actually tipped out the barbacks at the end of each shift. Although Sabolic testified that he always tipped the barbacks between 10% and 20% at the conclusion of each shift, he deducted only 10% for the tip outs on his federal income tax return for each year at issue. In fact, when the IRS itself recalculated Sabolic’s tip income, they allowed a reduction for

Earned Income Tax Credit (Refundable) 25

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tip outs of 10% for each year at issue. Although ideally, Sabolic should have kept track of these tip out amounts, the fact that he did not do so given the facts and circumstances does not by itself render his logs inadequate.

Third, the IRS claimed that the logs are inadequate because they appeared to be missing days. Sabolic worked Monday through Thursday from 6 p.m. until 2 a.m. with an hour break each day for all of the tax years under audit. At times, Sabolic varied from his usual routine to take vacations or work flexible hours. Each MGM Grand worker had an employee identification number and terminal where he or she swiped in when arriving and swiped out when leaving or taking a break. To the extent that the log days did not match up with the days from the MGM Grand’s records, Sabolic offered the explanation that frequently the time system would be down or faulty and cause disparities between his records and those that MGM Grand provided.

The IRS also contended that Sabolic’s logs were inadequate because they did not precisely match up with the information on his Forms W-2. For the three years under audit Sabolic’s logs were off by $3,739, $271, and $1,024, respectively. The IRS acknowledged that the small difference for the second year could be due to timing differences as the Form W-2 was generated on the basis of pay periods which did not correspond precisely to the calendar year. Although the discrepancies for 2009 and 2011 were larger, they could also be partially reconciled by the pay period difference. Furthermore, Sabolic submitted evidence that the MGM Grand time system that tracked tips had malfunctioned several times throughout the tax years at issue. Given Sabolic’s habitual careful recordkeeping, the Tax Court found that his logs were a substantially accurate account of his tip income for all the tax years at issue.

Because Sabolic was able to demonstrate that he routinely kept a daily record of his tips and reported amounts that were substantially the same as his records, the Tax Court found that the IRS’s method did not reflect Sabolic’s income as accurately as Sabolic’s logs. Therefore, the court found that Sabolic met his burden of proof and rejected the IRS’s recomputation of the tips.

APPENDIX B

EARNED INCOME TAX CREDIT (REFUNDABLE)The earned income tax credit (EITC or EIC) is a tax credit for certain people who work and have earned income and AGI under certain limits. The EITC is a refundable credit. Receiving the payments in advance was not very popular and was repealed back in 2011. A taxpayer looking to claim the credit must file a return.

Earned income includes all of the following:

Wages, salaries, and tips

Union strike benefits

Long-term disability benefits received prior to minimum retirement age

Net earnings from self-employment

Non-taxable combat pay (only if elected and included in taxable income)

Earned income does not include:

Interest and dividends

Pensions

Social Security

Unemployment benefits

Alimony

Child support

26 Appendix B

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The American Rescue Plan Act of 2021 established several changes to the Earned Income Tax Credit. Most changes are effective only for the tax year 2021 and certain changes are effective for the tax year 2021 and continue in future tax years.

WHO MAY CLAIM THE EITC?

To claim the EITC, taxpayers must meet all of the following rules:

Investment income must be $10,000 or less for 2021.

One of the changes to the EITC for 2021 and future years under the American Rescue Plan Act of 2021include an increase in investment income limit—investment income must be $10,000 or less for 2021 (up from $3,650), and taxable years beginning after 2021 shall be increased for inflation.

Generally, if married, the taxpayers cannot file separately (MFS); they must file a joint return (MFJ). EITC allowed in case of certain separated spouses—special rule for a separated spouse.

Another one of the changes to the EITC for 2021 and future years under the American Rescue Plan Act of 2021 include EITC allowed in case of certain separated spouses. Special rule for a separated spouse – An individual shall not be treated as married if such individual:

is married and does not file a joint return for the taxable year,

resides with a qualifying child of the individual for more than one-half of such taxable year, and

during the last 6 months of such taxable year, does not have the same principal place of abode as the individual’s spouse, or

has a decree, instrument, or agreement (other than a decree of divorce) with respect to the individual’s spouse and is not a member of the same household with the individual’s spouse by the end of the taxable year

Taxpayer(s) and all qualifying children must have a valid Social Security number, issued before the due date of the return including any valid extensions. If the child was born and died during the year, the child does not need a SSN.

Another change to the EITC for 2021 and future years under the American Rescue Plan Act of 2021includes a taxpayer is eligible for childless earned income credit in case of qualifying children who fail to meet certain identification requirements—if a qualifying child does not have a valid SSN, the taxpayer may claim the earned income tax credit for individuals with no qualifying children.

Taxpayer must be a U.S. citizen or a nonresident alien married to a U.S. citizen or resident alien and filing a joint return.

Taxpayer cannot file Form 2555 related to foreign-earned income.

Taxpayer cannot be the qualifying child of another person.

Taxpayer must have earned income; however, 2021 earned income and AGI cannot be more than:

Earned Income Tax Credit (Refundable) 27

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0 $21,430 $27,380

1 $42,158 $48,108

2 $47,915 $53,865

3 + $51,464 $57,414

The American Rescue Plan Act of 2021 increases the phaseout amounts for taxpayers with no qualifying children for 2021 only. The completed phaseout amounts for taxpayers with no qualifying children increases to $21,430 (up from $15,980) and $27,380 MFJ (up from $21,920) for 2021 EITC only.

Taxpayers with no qualifying children, the taxpayer must meet the following criteria:

Be age 25 but younger than 65 at the end of the year (see below—temporarily changed for 2021 only under the American Rescue Plan Act of 2021)

Live in the United States for more than half of the year

Cannot be the dependent of another person

Earned Income Credit for 2021 only – Taxpayers with no qualifying children

Under the American Rescue Plan Act of 2021, the EITC changes for 2021 only are primarily aimed at strengthening the earned income tax credit for individuals with no qualifying children. Some of the 2021 only changes to the EITC for individuals with no qualifying children include:

Decrease in minimum age for taxpayers with no qualifying children (previously had to be age 25):

Generally, age 19

In the case of a specified student, age 24

Specified student – an individual who is an eligible student during at least 5 calendar months during the taxable year

In the case of a qualified former foster youth or a qualified homeless youth, age 18

Qualified former foster youth – an individual who on or after the date that such individual attained age 14, was in foster care provided under the supervision or administration of an entity administering (or eligible to administer) a plan under part B or part E of title IV of the Social Security Act

Qualified homeless youth – an individual who certifies, that such individual is either an unaccompanied youth who is a homeless child or youth, or is unaccompanied, at risk of homelessness, and self-supporting

Elimination of maximum age for taxpayers with no qualifying children (previously had to be younger than age 65)

Taxpayers with a qualifying child, a child must meet four tests, the relationship, age, residency, and joint return tests:

Relationship Test - To be a qualifying child, a child must be:

Son, daughter, stepchild, foster child, adopted child, or a descendant of any of them (for example, a grandchild); or

28 Appendix B

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Brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them (for example, a niece or nephew)

Age Test - To be a qualifying child, a child must be:

Under age 19 at the end of the year and younger than the taxpayer (or taxpayer’s spouse, if filing jointly);

Under age 24 at the end of the year, a student, and younger than the taxpayer (or taxpayer’s spouse, if filing jointly); or

Permanently and totally disabled at any time during the year, regardless of age

Residency Test - Child must have lived with the taxpayer in the U.S. for more than half of the year

Joint Return Test - Child can’t file a joint return for the year (or child and his or her spouse file a joint return only to claim a refund of income tax withheld or estimated tax paid).

Important: Sometimes a child meets the rules to be a qualifying child of more than one person. However, only one person can treat that child as a qualifying child and claim the EITC using that child. Taxpayers can choose which person will claim the EITC. If the taxpayers do not reach an agreement and more than one person claims the EITC using the same child, the tiebreaker rule applies, and the parent with whom the child lived the longest during the year receives the credit. If the child lived with each parent the same amount of time, the parent with the higher AGI receives the credit.

MAXIMUM EITC

The maximum credit is 40% (45% if three or more children) of the first $14,950 of earned income in 2021 with two qualifying children or with three or more qualifying children.

The maximum amount of credit for 2021 is:

$6,728 with three or more qualifying children

$5,980 with two qualifying children

$3,618 with one qualifying child

$1,502 with no qualifying children

The American Rescue Plan Act of 2021 increases the credit percentage and the earned income amount for taxpayers with no qualifying children for 2021 only, which increases the maximum amount of credit for taxpayers with no qualifying children to $1,502 (up from $543) for 2021 EITC only.

The American Rescue Plan Act of 2021 also established a special rule for determining earned income for purposes of the earned income tax credit for 2021 only—if the earned income of the taxpayer for 2021 is less than the earned income of the taxpayer for 2019, the credit allowed, at the election of the taxpayer, be determined by substituting:

such earned income for the taxpayer’s taxable year beginning in 2019, for

such earned income for the taxpayer’s taxable year beginning in 2021

DISALLOWANCE OF THE EITC

Certain errors may cause the IRS to deny a taxpayer the EITC. If the denial is because of taxpayer error due to reckless or intentional disregard of the rules, the taxpayer cannot claim the EIC for the next two years. If the error is due to fraud, the taxpayer cannot claim the EITC for the next 10 years. A taxpayer who wants (and meets the requirements) to

Child and Dependent Care Credit (Non-refundable) 29

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claim the EITC must attach Form 8862 to his return if the EITC was reduced or disallowed for any reason other than a math or clerical error for a year after 1996.

A taxpayer can claim the EITC without filing Form 8862 if he meets all the EITC eligibility requirements and either of the following applies:

After the EIC was reduced or disallowed in an earlier year:

The taxpayer filed Form 8862 (or other documents) and the EIC was then allowed, and

EITC was not reduced or disallowed again for any reason other than a math or clerical error.

The taxpayer is taking the EITC without a qualifying child and the only reason the EITC was disallowed in the earlier year was that a child listed on Schedule EIC was not his qualifying child.

PAID PREPARER REQUIREMENTS

Paid preparers of federal income tax returns or claims for refund involving the earned income credit must meet the due diligence requirements in determining if the taxpayer is eligible for, and the amount of, the EITC. Failure to do so could result in a $545 penalty for each failure filed in 2022 (generally 2021 tax returns filed in 2022). See IRC section 6695(g). A tax preparer can use Form 8867 to document due diligence.

APPENDIX C

CHILD AND DEPENDENT CARE CREDIT (NON-REFUNDABLE)To qualify for this credit, a taxpayer must meet all the following tests:

The taxpayer must file Form 1040, 1040-SR, or 1040-NR.

The filing status must be single, head of household, qualifying widow(er) with dependent child, or married filing jointly. Married couples must file a joint return unless an exception exists.

The care must be for one or more qualifying person(s).

The taxpayer (and spouse if married) must have earned income during the year.

The taxpayer must pay the expenses so the taxpayer (and spouse if married) can work or look for work.

Payments cannot go to the following individuals:

A spouse

A person who is a dependent of the taxpayer or the taxpayer's child if under age 19 at the end of the year (even if not a dependent)

The parent of the qualifying person if the qualifying person is the taxpayer's child (under age 13)

The taxpayer must identify the care provider on the tax return (name, address, TIN).

If taxpayers exclude dependent care benefits provided by a dependent care benefits plan, the total exclusion must be less than the dollar limit for qualifying expenses ($3,000 if one qualifying person or $6,000 if two or more qualifying persons).

A qualifying individual for the child and dependent care credit is:

The taxpayer’s dependent qualifying child who was under age 13 when the care was provided,

The taxpayer’s spouse who was physically or mentally incapable of caring for himself or herself and lived with the taxpayer for more than half of the year, or

An individual who was physically or mentally incapable of caring for himself or herself, lived with the taxpayer for more than half of the year, and either: (a) was taxpayer’s dependent; or (b) could have been taxpayer’s dependent except that:

He or she received gross income of $4,300 or more in 2021

30 Appendix C

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He or she filed a joint return, or

The taxpayer (or the taxpayer’s spouse if filing jointly) could have been claimed as a dependent on another person's return.

The credit is available only for employment-related expenses. The amount of employment-related expenses is capped to $3,000 for one qualifying individual or $6,000 for two or more qualifying individuals. The taxpayer may apply the limitations for two or more qualifying individuals in unequal proportions. For example, suppose the taxpayer had employment-related expenses of $4,000 for one qualifying individual and $1,500 for a second qualifying individual. In these circumstances, the taxpayer may take the aggregate payment of $5,500 into account when determining the credit, even though the expenses related to one of the qualifying individuals exceeded $3,000.

To qualify for the credit, a taxpayer must have one or more qualifying persons. However, it is possible a qualifying child could have no expenses and a second qualifying child could have expenses exceeding $3,000. Since there are two qualifying children, the $6,000 limit would still be used to compute the credit. The taxpayer can use both qualifying children and the $6,000 limit to figure the credit. On Form 2441, list zero for the one child and the actual amount for the second child.

The credit is a percentage of work-related expenses. To claim the credit, the taxpayer (and spouse if filing jointly) must have earned income during the year. Child and dependent care expenses must be work-related to qualify for the credit. To be work-related, expenses must allow the taxpayer to work or look for work. If married, generally both spouses must work or look for work. One spouse is treated as working during any month he/she is a full-time student or isn't physically or mentally able to care for him/herself. Work also includes actively looking for work. However, if you don't find a job and have no earned income for the year, you can't take this credit.

TIP: A spouse who is a full-time student or incapable of self-care is treated as having earned income of at least $250/month if there is one qualifying person in the taxpayer’s home or at least $500/month for two or more qualifying persons.

Child and Dependent Care Credit for 2021 Only

The American Rescue Plan Act of 2021 brought about significant changes to the Child and Dependent Care Credit for 2021 only. In addition to increasing the amount of qualified expenses that may be considered to $8,000 for one qualifying person and $16,000 for two or more qualifying persons, the act also makes the credit refundable and makes the credit available to more taxpayers. The Child and Dependent Care Credit changes apply only to the 2021 tax year.

Changes to the Child and Dependent Care Credit for 2021 include:

The credit is refundable for qualifying taxpayers (previously nonrefundable)

Increase in amount of qualifying expenses to $8,000 if one qualifying person and $16,000 if more than one qualifying person (up from $3,000 if one qualifying person and $6,000 if more than one qualifying person)

Increase in applicable percentage – the applicable percentage begins at 50% for taxpayers with AGI less than $125,000 (previously the applicable percentage began at 35% for taxpayers with AGI less than $15,000)

Application of phaseout to high income individuals – the “phaseout percentage” is 20% reduced (but not below zero) by 1% for each $2,000 (or fraction thereof) by which the taxpayer’s AGI for the taxable year exceeds $400,000 (previously the minimum percentage was 20%)

Child Tax Credit 31

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CHILD TAX CREDITENHANCED CHILD TAX CREDIT

The Tax Cuts and Jobs Act of 2017 temporarily provides an enhanced Child Tax Credit, which increases the child tax credit per qualifying child and provides an additional credit for qualifying dependents other than qualifying children. The tax act provision is effective for taxable years beginning after December 31, 2017, and expires for taxable years beginning after December 31, 2025.

The Tax Cuts and Jobs Act temporarily increases the child tax credit to $2,000 per qualifying child. Under the tax act, the child tax credit maximum amount refundable may not exceed $1,400 per qualifying child.

The Tax Cuts and Jobs Act also temporarily enhances the child tax credit by allowing an additional $500 nonrefundable credit for qualifying dependents other than qualifying children. Examples of a qualified dependent include dependents over age 17, such as children in college or a dependent parent.

The tax act generally retains the present-law definition of dependent. The tax act also retains the present-law age limit for a qualifying child for purposes of the child tax credit. Thus, a qualifying child is an individual who has not attained age 17 during the taxable year. Therefore, a dependent child age 17 or older is not a qualifying child for purposes of the child tax credit but is a qualifying dependent for purposes of the child tax credit.

The enhanced Child Tax Credit for qualifying children and qualifying dependents other than qualifying children applies for taxable years 2018 through 2025.

CHILD TAX CREDIT FOR QUALIFYING CHILD

The child tax credit for a qualifying child is available for taxpayers with dependents under the age of 17. For 2021, the full amount of the credit is $2,000 for each qualifying child. However, the credit amount is phased out by $50 for each $1,000 by which the taxpayer's modified adjusted gross income exceeds a threshold amount. The child tax credit for a qualifying child is refundable to the extent of 15% of the taxpayer’s earned income in excess of $2,500. For 2021, the maximum amount refundable for the child tax credit is $1,400 per qualifying child. This amount is adjusted for inflation.

The full amount of the credit is $2,000 per qualifying child in 2021. The amount of the child tax credit is reduced by $50 for each $1,000 (or fraction thereof) by which the taxpayer’s modified adjusted gross income exceeds specified amounts. The Tax Cuts and Jobs Act of 2017 modifies the adjusted gross income phaseout thresholds. For 2021, the credit begins to phase out for taxpayers with adjusted gross income in excess of $400,000 (for married taxpayers filing a joint return) and $200,000 (for all other taxpayers). These phaseout thresholds are not indexed for inflation. “Modified adjusted gross income” for this purpose is simply AGI increased by otherwise excluded income from foreign sources or U.S. territories.

Additionally, the tax act provides that, in order to receive the child tax credit for a qualifying child (i.e., both the refundable and nonrefundable portion), a taxpayer must include a Social Security number for each qualifying child for whom the credit is claimed on the tax return. For these purposes, a Social Security number must be issued before the due date for the filing of the return for the taxable year.

The tax act generally retains the present-law definition of dependent. The tax act also retains the present-law age limit for a qualifying child. A qualifying child for purposes of the child tax credit is a child who meets the following criteria of seven tests (relationship, age, support, residency, dependent, joint return, and citizenship):

Is the taxpayer’s son, daughter, stepchild, eligible foster child, adopted child, brother, sister, stepbrother, stepsister, half brother, half sister, or a descendant of any of them (a grandchild, niece, or nephew)

Was younger than age 17 at the end of the tax year and younger than the taxpayer (or spouse if filing jointly)

Did not provide more than half of his or her own support for the year

32 Appendix C

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Lived with the taxpayer for more than half of the year

Is claimed as a dependent on the taxpayer’s return

Does not file a joint return for the year (or files it only to claim a refund of withheld income tax or estimated tax paid)

Is a U.S. citizen, a U.S. national, or a resident of the United States

In determining whether a person is a qualifying child, treat a person who was born or died as having lived with the taxpayer for the entire tax year if the taxpayer's home was the person's home the entire time he was alive. Temporary absences for special circumstances, such as school, vacation, business, medical care, military service, or detention in a juvenile facility, count as time the child lived with the taxpayer.

Child Tax Credit for 2021 Only

The American Rescue Plan Act of 2021 introduces Child Tax Credit (CTC) improvements for 2021 only. The child tax credit increases to $3,000 per qualifying child ($3,600 for a qualifying child who has not attained age 6 as of the close of the calendar year) and is fully refundable for qualifying taxpayers. Currently, the CTC improvements apply only to the 2021 tax year.

Child Tax Credit improvements for 2021 include:

The credit is fully refundable for qualifying taxpayers (previously partially refundable)

Qualifying child age increases to younger than age 18 (previously younger than age 17)

The credit amount increases per qualifying child to $3,000 for children ages 6 to 17 and $3,600 for children under age 6 (up from $2,000 per qualifying child under age 17)

MAGI phaseout thresholds are reduced to $150,000 for joint return or surviving spouse, $112,500 for head of household, and $75,000 for all others (previously $400,000 for married filing jointly and $200,000 for all others)

Advance payment of credit – periodic payments to taxpayers during the calendar year (July 1 through December 31 for 2021). The annual advance amount is estimated as being equal to 50% of the amount which would be treated as allowed. Taxpayers can elect not to receive advance payments. Note: The amount of credit allowed to any taxpayer for any taxable year shall be reduced (but not below zero) by the aggregate amount of advanced payments made to such taxpayer during such taxable year.

CHILD TAX CREDIT FOR QUALIFYING DEPENDENTS OTHER THAN QUALIFYING CHILD

The Tax Cuts and Jobs Act of 2017 also temporarily enhances the child tax credit by allowing an additional $500 nonrefundable credit for qualifying dependents other than qualifying children. The tax act generally retains the present-law definition of dependent. Examples of a qualified dependent include dependents over age 17, such as children in college or a dependent parent.

The tax act also retains the present-law age limit for a qualifying child for purposes of the child tax credit. Thus, a qualifying child is an individual who has not attained age 17 during the taxable year. Therefore, a dependent child age 17 or older is not a qualifying child for purposes of the child tax credit but is a qualifying dependent for purposes of the child tax credit.

The Social Security number (SSN) requirement, for the child tax credit, does not apply to a non-child dependent for whom the $500 nonrefundable credit is claimed. Unlike for a qualifying child, where the taxpayer must include an SSN for each qualifying child for whom the child tax credit is claimed, the SSN is not required for a qualifying dependent for purposes of the child tax credit.

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For 2021, the credit begins to phase out for taxpayers with adjusted gross income in excess of $400,000 (for married taxpayers filing a joint return) and $200,000 (for all other taxpayers). These phaseout thresholds are not indexed for inflation.

SAVER'S CREDIT (NON-REFUNDABLE)A taxpayer may claim the Retirement Savings Contributions Credit (Saver’s Credit) for qualified contributions or deferrals made to certain retirement plans. The credit amount begins at 50% of the taxpayer’s contributions to the plan, contributions up to $2,000 ($4,000 MFJ), and is reduced depending on the taxpayer’s adjusted gross income (AGI) and filing status. The Saver’s Credit is a nonrefundable credit and the maximum credit is $1,000 ($2,000 MFJ). Depending on the taxpayer's specific income level and filing status, the credit may be reduced to 20% or 10%.

Eligible for the Retirement Savings Contributions Credit (Saver’s Credit) if:

Age 18 or older;

Not a full-time student; and

Not claimed as a dependent on another person’s return.

The applicable percentage of the retirement plan or IRA contributions (up to $2,000 per individual, $4,000 if married filing jointly) for the tax credit depends upon adjusted gross income and tax filing status. The applicable credit percentages are as follows:

2021 Saver's Credit

Credit Rate Married Filing Jointly Head of Household All Other Filers*

50% of your contribution AGI not more than $39,500 AGI not more than $29,625 AGI not more than $19,750

20% of your contribution $39,501 - $43,000 $29,626 - $32,250 $19,751 - $21,500

10% of your contribution $43,001 - $66,000 $32,251 - $49,500 $21,501 - $33,000

0% of your contribution AGI more than $66,000 AGI more than $49,500 AGI more than $33,000

*Single, married filing separately, or qualifying widow(er)

The Saver’s Credit can be taken for contributions to a traditional or Roth IRA; 401(k), SIMPLE IRA, SARSEP, 403(b), 501(c)(18) or governmental 457(b) plan; and voluntary after-tax employee contributions to qualified retirement and 403(b) plans. Rollover contributions are not eligible for the Saver’s Credit. Also, eligible contributions may be reduced by any recent distributions the taxpayer received from a retirement plan or IRA.

For example, suppose Jill, who works at a retail store, is married filing jointly and earned $37,000 in 2021. Jill’s husband was unemployed in 2021 and didn’t have any earnings. Jill contributed $1,000 to her IRA in 2021. After deducting her IRA contribution, the adjusted gross income shown on her joint return is $36,000. Jill may claim a 50% credit, $500 credit, for her $1,000 IRA contribution.

34 Appendix D

APPENDIX D

FEDERAL DECLARED DISASTER AREASpecial tax law provisions may help taxpayers and businesses recover financially from the impact of a disaster, especially when the federal government declares their location to be a major disaster area. Depending on the circumstances, the IRS may grant additional time to file returns and pay taxes. Both individuals and businesses in a federally declared disaster area can get a faster refund by claiming losses related to the disaster on the tax return for the previous year, usually by filing an amended return.

APPENDIX E

ITEMS EXCLUDED FROM GROSS INCOMEUnless excluded by a specific Code provision, all transactions that represent accretions of wealth to the taxpayer are taxable. The Code provides specific exclusions for the following items:

Certain Death Benefits

Gross income generally does not include amounts received (whether in a single sum or otherwise) under a life insurance contract, if such amounts are paid by reason of the death of the insured. This rule does not apply if the taxpayer has received the life insurance policy in a transfer for value (as when the original policy owner transfers the policy to someone else in a business transaction).

Gifts and Inheritances

Gross income does not include the value of property acquired by gift, bequest, devise, or inheritance. Many taxpayers are confused on this point because of the “gift tax” that applies to the maker of the gift.

Interest on State and Local Bonds

Gross income generally does not include interest on any obligation of a State or political subdivision thereof. This exclusion does not apply to any private activity bond which is not a qualified bond, arbitrage bond, or non-registered bond.

Compensation for Injuries or Sickness

Code section 104(a)(2) provides that gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. The regulations define the term “damages” as meaning an amount received (other than workers’ compensation) through prosecution of a legal suit or action, or through a settlement agreement entered into in lieu of prosecution.

Note that amounts received as a “before the fact” waiver are taxable, as opposed to “after the fact” settlements. Take, for example, the case of Nichelle Perez, a 29-year-old California woman who agreed to be an egg donor for a fertility company. In order to perform her obligations under the agreement, she had to undergo a series of painful procedures that included syringes, injections, and a surgical procedure under anesthesia. All of these procedures involved risk and significant pain and discomfort. Nichelle excluded the payments from the fertility company from her tax return, reasoning that they were essentially compensation for pain and suffering.

Although settlement payments for pain and discomfort of this type would normally be excluded from income as damages for personal physical injury, Perez’s case was different because there was not an “after the fact” settlement, but rather a waiver. The Tax Court has held on several occasions that an advance waiver of possible future damages for personal injuries constitutes taxable income. While the court believed that the series of medical procedures that culminated in the retrieval of Perez’s eggs was painful and dangerous to her present and future health, what matters is

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that she voluntarily signed a contract to be paid to endure them. This means that the money she received was not “damages”.

The court observed that Perez very clearly had a legally recognized interest against bodily invasion. But it held that when she forgoes that interest and consents to such intimate invasion for payment, any amount she receives must be included in her taxable income. Had the Donor Source or the clinic exceeded the scope of Perez’s consent, Perez may have had a claim for damages. But the injury here, as painful as it was to Perez, was exactly within the scope of the medical procedures to which she contractually consented. Her physical pain was a byproduct of performing a service contract, and the court found that the payments were made not to compensate her for some unwanted invasion against her bodily integrity but to compensate her for services rendered.

Underlying the court’s decision was its concern about the mischief that ruling in Perez’s favor might cause. A professional boxer, the court pointed out, could argue that some part of the payments he received for his latest fight is excludable because they are payments for his bruises, cuts, and nosebleeds. A hockey player could argue that a portion of his million-dollar salary is allocable to the chipped teeth he invariably suffers during his career. The same would go for the brain injuries suffered by football players and the less-noticed bodily damage daily endured by working men and women on farms and ranches, in mines, or on fishing boats. While the court recognized that some portion of the compensation paid to all these people reflects the risk that they will feel pain and suffering, it is a risk of pain and suffering that they agree to before they begin their work. For that reason, those payments are taxable compensation and not excludable damages.

Amounts received under Accident and Health Plans

Generally, amounts received by an employee through accident or health insurance for personal injuries or sickness are not included in gross income if the amount is paid to reimburse the taxpayer for expenses incurred for the medical care of the taxpayer, his or her spouse or dependents, and any child of the taxpayer who as of the end of the taxable year has not attained age 27.

Contributions by Employer to Accident and Health Plans

Generally, gross income of an employee does not include employer-provided coverage under an accident or health plan. Amounts contributed by the employer to any Archer MSA of an employee are treated as employer-provided coverage for medical expenses under an accident or health plan, as are amounts contributed by such employee’s employer to any health savings account. However, gross income of an employee includes employer-provided coverage for qualified long-term care services to the extent that such coverage is provided through a flexible spending or similar arrangement.

Rental Value of Parsonages

In the case of a minister of the gospel, gross income does not include: (1) the rental value of a home furnished to him or her as part of his or her compensation; or (2) the rental allowance paid to him or her as part of compensation, to the extent used by him or her to rent or provide a home and to the extent such allowance does not exceed the fair rental value of the home, including furnishings and appurtenances such as a garage, plus the cost of utilities. A “minister of the gospel” is a clergyman of any faith, but only if duly ordained, commissioned, or licensed.

Certain Income from Discharge of Indebtedness

While the discharge or cancellation of debt generally results in income to the debtor, gross income does not include any such amount if: (1) the discharge occurs in a bankruptcy case; (2) the discharge occurs when the taxpayer is insolvent; (3) the indebtedness discharged is qualified farm indebtedness; (4) in the case of a taxpayer other than a C corporation, the indebtedness discharged is qualified real property business indebtedness; (5) the price reduction occurs when the seller reduces the taxpayer's debt and the taxpayer is not insolvent or bankrupt; (6) the cancellation of certain student loan indebtedness (a) if the creditor canceled the debt due to the performance of services or (b) if due to death or total and permanent disability for discharges of loans after December 31, 2017, and before January 1,

36 Appendix E

2026, under the Tax Cuts and Jobs Act; (7) the indebtedness discharged is qualified principal residence indebtedness which is discharged before January 1, 2026.

Qualified principal residence indebtedness is debt incurred in acquiring, constructing, or substantially improving a principal residence and secured by the principal residence. It also includes any debt resulting from the refinancing of such debt but only to the extent of the prior debt. Cash taken during refinancing is not qualified principal residence indebtedness. Up to $2 million ($1 million married filing separate) may be excluded for debt discharged (or agreed to in writing) before January 1, 2021. This exclusion was retroactively extended to 2017 by the Bipartisan Budget Act of 2018. The passage of the Taxpayer Certainty and Disaster Tax Relief Act of 2019 further extended the exclusion until December 31, 2020. Then the Consolidated Appropriations Act, 2021 again extended the exclusion to discharges made before January 1, 2026, and also reduced the exclusion amount to $750,000 ($375,000 married filing separate) for discharges of indebtedness after December 31, 2020. Thus, for qualified principal residence indebtedness, up to $750,000 ($375,000 married filing separate) may be excluded for debt discharged 2021 through 2025.

Also, note that the insolvency exception only applies to the extent of the insolvency immediately before the cancellation or discharge. You were insolvent immediately before the cancellation to the extent that the total of all of your liabilities was more than the fair market value of all of your assets immediately before the cancellation. For example, suppose Harry received a cancellation of a $10,000 debt. Immediately before the cancellation, Harry’s liabilities exceed the value of his assets by $6,000, therefore he is insolvent to the extent of $6,000. Because the amount of the canceled debt was more than the amount by which he was insolvent immediately before the cancellation, Harry can exclude only $6,000 of the canceled debt from income under the insolvency exclusion and must include $4,000 of canceled debt in income.

Recovery of Tax Benefit Items

Gross income does not include income attributable to the recovery during the taxable year of any amount deducted in any prior taxable year to the extent such amount did not reduce the amount of tax imposed. Normally, the recovery of a deducted item must be included in income. For example, suppose the taxpayer deducted medical expenses in 20X0 but then was reimbursed for those expenses by his or her insurance company in 20X1. In that case, the taxpayer would have to report the 20X1 reimbursements in his or her 20X1 income.

On the other hand, suppose the taxpayer had the same expenses but did not itemize in 20X0, so those expenses did not reduce the amount of the 20X0 tax. In this case, the 20X1 reimbursements would not be included in income. Likewise, whether or not a state tax refund is included in income depends on whether the payment of the state tax that generated the refund reduced the prior year’s federal income tax.

Certain Combat Zone Compensation of members of the Armed Forces

Gross income does not include compensation received for active service in the Armed Forces of the United States for any month during any part of which such member served in a combat zone or was hospitalized as a result of wounds, disease, or injury incurred while serving in a combat zone. However, the exclusion does not apply to hospitalization for any month beginning more than 2 years after the date of the termination of combatant activities in a combat zone. With respect to commissioned officers, the exclusion applies to so much of the compensation as does not exceed the maximum enlisted amount.

Qualified Scholarships

Gross income does not include any amount received as a qualified scholarship by an individual who is a candidate for a degree at an educational organization. The term “qualified scholarship” means any amount received by an individual as a scholarship or fellowship grant to the extent the individual establishes that, in accordance with the conditions of the grant, such amount was used for qualified tuition and related expenses. “Qualified tuition and related expenses” means tuition and fees required for the enrollment or attendance of a student at an educational organization and


fees, books, supplies, and equipment required for courses of instruction at such an educational organization. Employees of educational organizations can also exclude qualified tuition reductions.

Two important exceptions apply to this exclusion. First, the exclusion does not apply to the extent the scholarship covers room and board. Second, the exclusion does not apply to any amount received which represents payment for teaching, research, or other services by the student required as a condition for receiving the qualified scholarship or qualified tuition reduction. Playing for a school’s sports teams, by the way, does not count as a “service required as a condition for receiving the qualified scholarship,” so athletic scholarships are excluded from income (except to the extent they are for room and board).

Meals or Lodging furnished for the Convenience of the Employer

Gross income does not include the value of any meals or lodging furnished to a taxpayer, his or her spouse, or any of his or her dependents by or on behalf of his or her employer for the convenience of the employer, but only if, in the case of meals, the meals are furnished on the business premises of the employer and, in the case of lodging, the employee is required to accept such lodging on the business premises of his employer as a condition of his employment.

Exclusion of Gain from Sale of Principal Residence

Code section 121 allows taxpayers to exclude a limited amount of gain resulting from the sale or exchange of property if the property has been owned and used as their principal residence for at least two years during the five-year period before the sale. Unmarried taxpayers may exclude up to $250,000 of gain from the sale of a qualifying residence, while married taxpayers meeting certain requirements and filing a joint return can exclude up to $500,000 of gain. Taxpayers may exclude gain from the sale of a principal residence under Code section 121 only once every two years.

Amounts received under Insurance Contracts for certain Living Expenses

In the case of an individual whose principal residence is damaged or destroyed by fire, storm, or other casualty, or who is denied access to his principal residence by governmental authorities because of the occurrence or threat of occurrence of such a casualty, gross income does not include amounts received by such individual under an insurance contract which are paid to compensate or reimburse such individual for living expenses incurred for himself and members of his household resulting from the loss of use or occupancy of such residence.

Cafeteria Plans

No amount shall be included in the gross income of a participant in a cafeteria plan solely because, under the plan, the participant may choose among the benefits of the plan. However, in the case of a highly compensated participant, the exclusion does not apply to any benefit attributable to a plan year for which the plan discriminates in favor of highly compensated individuals. Furthermore, in the case of a key employee, the exclusion does not apply to any benefit attributable to a plan for which the statutory nontaxable benefits provided to key employees exceed 25% of the aggregate of such benefits provided for all employees under the plan. The term “key employee” means an employee who, at any time during the 2021 plan year, is: (1) an officer having an annual compensation of more than $185,000; (2) a 5% owner of the business, at any compensation level (a 5% owner is someone who owns more than 5% of the business); or (3) a 1% owner of the business having an annual compensation from the employer of more than $150,000.

Educational Assistance Programs

Employers can exclude up to $5,250 of educational assistance provided to an employee under an educational assistance program (a separate written plan that provides educational assistance only to employees) from the employee's wages each year. This does not include payments for education that furthers the abilities of a worker in their current position, as it is excludible as a tax-free fringe benefit.

Dependent Care Assistance Programs

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Payments incurred by an employer for dependent care assistance under a written plan are excluded from an employee’s gross income. The amount an employee can exclude cannot exceed the employee’s earned income (excluding employer dependent care assistance payments) or, for married employees, the earned income of the lower-earning spouse. The aggregate exclusion is further limited to $5,000 ($2,500 for a married individual filing separately). Any excess is includible in the tax year the dependent care services are provided.

Employer-Provided Dependent Care Assistance for 2021 Only

The American Rescue Plan Act of 2021 provides an increase in the exclusion for employer-provided dependent care assistance for 2021 only. For 2021, employees may exclude from income up to $10,500 ($5,250 MFS) received from an employer’s dependent care assistance program (up from $5,000 ($2,500 MFS)).

No amount is excludable unless the name, address, and (except in the case of a tax-exempt service-provider) taxpayer identifying number (TIN) of the person providing the dependent care services are included on the employee's return. The employee can use Form W-10 to ask for this information from the service provider. Failure to provide this information is excused if the employee exercised due diligence in trying to do so.

Certain Foster Care Payments

Gross income shall not include amounts received by a foster care provider during the taxable year as qualified foster care payments.

Certain Fringe Benefits

Code section 132 contains a list of tax-free fringe benefits that an employer may provide to employees. Among those benefits are no additional cost services, qualified employee discounts working condition fringe benefits, de minimis fringe benefits, qualified transportation fringe benefits, qualified moving expense reimbursements (temporarily repealed), and employer-provided retirement advice.

The TCJA repeals the exclusion of qualified moving expense reimbursements from gross income and wages (except for members of the Armed Forces) for taxable years beginning after December 31, 2017, and before January 1, 2026. All moving expenses paid or reimbursed for taxable years 2018 through 2025, will be taxable to the employee (except for members of the Armed Forces) and subject to tax withholding.

Certain Military Benefits

Gross income does not include any allowance or in-kind benefit (other than personal use of a vehicle) that is received by any member or former member of the uniformed services of the United States or any dependent of such member by reason of such member’s status or service as a member of such uniformed services.

Income from United States Savings Bonds used to pay Higher Education Tuition and Fees

Under the Education Savings Bond Program, a taxpayer may exclude all or part of the interest received on the redemption of qualified U.S. savings bonds during the year if the taxpayer uses that interest to pay for qualified higher educational expenses during the same year. Married taxpayers must file jointly to qualify for the exclusion.

Qualified U.S. savings bonds – A qualified U.S. savings bond is a series EE bond issued after 1989 or a series I bond. The bond must be in the taxpayer’s name (sole owner) or jointly held with a spouse. The taxpayer must be at least 24 years old before the bond’s issue date. The issue date of a bond may be earlier than the date the taxpayer purchased the bond because the issue date assigned to a bond is the first day of the month in which it is purchased.


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Qualified expenses – Qualified higher educational expenses are tuition and fees required for a taxpayer and dependents (for whom an exemption is claimed) to attend an eligible educational institution. Qualified expenses include any contribution made to a qualified tuition program or to a Coverdell education savings account.

Qualified expenses do not include expenses for books, room and board, or for courses involving sports, games, or hobbies that are not part of a degree or certificate-granting program.

Eligible educational institutions – These institutions include most public, private, and nonprofit universities, colleges, and vocational schools that are accredited and are eligible to participate in student aid programs run by the Department of Education.

Amount excludable – If the total proceeds (interest and principal) from the qualified U.S. savings bonds redeemed during the year are not more than the adjusted qualified higher education expenses for the year, the taxpayer may exclude all of the interest. If the proceeds are more than the expenses, the taxpayer may exclude only part of the interest. To determine the amount to exclude from income, divide the qualified expenses by the total bond proceeds. Multiply this percentage by the amount of bond interest to arrive at the amount excluded from income. The remainder of the interest is included in income.

Modified adjusted gross income limit – The interest income exclusion is phased out at certain levels of modified adjusted gross income (MAGI). For 2021, the exclusion begins to phase out for MAGI above $124,800 for joint returns and $83,200 for all other returns. The exclusion is completely phased out for MAGI of $154,800 or more for joint returns and $98,200 or more for all other returns.

Energy Conservation Subsidies provided by Public Utilities

Gross income does not include the value of any subsidy provided (directly or indirectly) by a public utility to a customer for the purchase or installation of any energy conservation measure.

Adoption Assistance Programs

Employees can exclude from gross income the qualified adoption expenses paid or reimbursed by an employer under an adoption assistance program. The aggregate amount of amounts paid or expenses incurred that may be taken into account for purposes of the exclusion for all tax years with respect to the adoption of a child by the taxpayer is (per child adopted):

For 2021, the amount that can be excluded from an employee’s gross income for the adoption of a child with special needs is $14,440 ($14,440 allowed for the adoption of a child with special needs even if no qualified expenses).

For 2021, the maximum amount that can be excluded from an employee’s gross income for other adoptions is the amounts paid or expenses incurred up to $14,440 (the lesser of amounts paid/expenses incurred or $14,440 for the adoption of a child without special needs).

The amount of adoption assistance that can be excluded from an employee’s gross income is phased out depending on the taxpayer’s modified adjusted gross income (MAGI). In 2021, the phaseout begins at MAGI in excess of $216,660 and is completely phased out for taxpayers with MAGI of $256,660 or more.

Tax benefits for adoption include both a tax credit for qualified adoption expenses paid to adopt an eligible child and an exclusion from income for employer-provided adoption assistance. The credit is nonrefundable, which means it's limited to the tax liability for the year. However, any credit in excess of tax liability may be carried forward for up to five years. To prevent a double benefit, no adoption credit is allowed for expenses for which an income tax deduction (income excluded from gross income) is allowed, or for expenses to the extent funds for the expenses are received under a federal, state, or local program.

Disaster Relief Payments

Gross income shall not include any amount received by an individual as a qualified disaster relief payment.

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