For 2009 and 2010, the American opportunity tax credit provides increased credit amounts for higher education expenses. This article discusses how taxpayers can best take advantage of the credit. The American opportunity tax credit,1 created by the American Recovery and Reinvestment Act of 2009,2 is basically a new and improved Hope scholarship credit for the 2009 and 2010 tax years. The new credit is for 100% of the first $2,000 paid for eligible educational expenses and 25% of the next $2,000 paid, for a total maximum credit of $2,500. In addition to fees, qualifying expenses now include course materials, including textbooks.3 This addition can be significant when tuition is largely covered by scholarships but the cost of books is not. In addition, 40% of the credit is refundable (although the credit is not refundable if a dependent who is subject to the kiddie tax takes the credit).4
The new phaseout range for the credit on a married filing jointly (MFJ) return begins at $160,000 and ends at $180,000 ($80,000 and $90,000, respectively, for single and head of household status), so high-income taxpayers can lose the credit altogether.5 High-income taxpayers may also lose the benefits of some of their exemptions. However, Letter Ruling 2002360016 stated that taxpayers could forgo the exemption and give the education credit to their dependent student if the student could derive a greater benefit.
In addition, even if the taxpayer actually paid for the education, the student can still take the credit if the dependent had a tax liability that could be reduced by the credit. The possibility of this being a viable option was complicated by the reduction of the exemption phaseout by two-thirds for 2009. However, for tax year 2010, the phaseout is repealed and the strategies discussed will depend on the taxpayer’s marginal rate and the dependent’s ability to use the credit. This article explores 2009 situations in which high-income taxpayers may benefit from not claiming the exemption and allowing the dependent to take the education credit instead.
Because exemptions begin to phase out at $166,800 for single taxpayers and $250,200 for married taxpayers filing jointly, high-income taxpayers could lose one or more exemptions. The percent of exemption phaseout is determined by taking the excess of adjusted gross income (AGI) over the beginning of the phaseout range, dividing that by $2,500, rounding the result to the next whole number, and multiplying it by 2%. The resulting number is then reduced by two-thirds in 2009 and subtracted from the amount of exemptions before the phaseout.7
In order to determine the effect of giving up an exemption, it is necessary to show the net tax effect for a high-income MFJ taxpayer giving up the exemption (see Exhibit 1). The result is that if the taxpayer gives up the exemption, the net tax effect is an additional $1,004. The income level assumed—$312,700—represents the approximate income level at which a full exemption ($3,650 for 2009) will be lost before the two-thirds reduction.
Dependent’s Ability to Take Advantage of the Credit
If the dependent taxpayer (assumed in Exhibit 1) is allowed to take the credit, the dependent is still not allowed the exemption but is allowed the standard deduction. For 2009, assuming earned income above this amount, the dependent’s standard deduction is $5,700. Exhibit 2 shows that the tax liability of a dependent with AGI of $15,500 is $1,053. If the dependent has education expenses of at least $1,053 (since the credit offsets 100% of the first $2,000 in expenses), his or her tax liabilities will be reduced to zero, and the benefit will exceed the parents’ loss by $49 ($1,053 – $1,004).
Is an income of $15,500 likely for a dependent college student? Given that the American opportunity credit is now available for the third and fourth years of college, it is possible. A student who started college in 2005 and graduated in four years would have graduated in spring 2009. If the student had started working soon after graduation, it would have been possible to achieve a taxable income of $15,500 for 2009.
With an appropriate mix of a taxpayer’s AGI and a dependent’s earned income, it may be more advantageous for a family to disclaim the dependency exemption for the child and allow the student to take the American opportunity credit on his or her own return. An analysis under various scenarios is necessary before this decision can be made.
Taxpayers or advisers with clients in this situation should look at the various options to determine if it is advisable to forgo the dependency exemption, even though it is allowable to the taxpayer, in order to allow a dependent student to take advantage of the credit.
Angelo (Tony) Falgiani is an associate professor emeritus in the Department of Accountancy at Western Illinois University–Quad Cities in Moline, IL. Kenneth Plucinski is an assistant professor of accounting at the State University of New York in Fredonia, NY. For more information about this article, contact Mr. Falgiani at firstname.lastname@example.org.
1 Sec. 25A(i).
2 American Recovery and Reinvestment Act of 2009, P.L. 111-5.
3 Sec. 25A(i)(3).
4 Sec. 25A(i)(6).
5 Sec. 25A(i)(4).
6 IRS Letter Ruling 200236001 (9/6/02).
7 Sec. 151(d)(3)(E).