A shareholder’s basis is the market value of his stock investment for income tax purposes. Earnings and profits are distributed to the shareholder based on the amount of stock owned. An increase in basis due to earnings and profits earned is included in taxable income reported by the shareholder on his annual income tax return. Tax credits are used and reported on an income tax return to reduce taxable income and the amount of tax owed. Credits do not directly affect a shareholder’s investment basis; they reduce the tax liability that results from the amount of taxable income for the year.
Types of Tax Credits
There are two types of tax credits: personal tax and refundable. Within these two categories are a variety of credits that are usable if they apply to the taxpayer’s situation and when specific requirements are met. The credits' effect on taxable income varies, and most are reported as separate line items added to arrive at a total credits amount. The amount of total credits reduces the amount of tax owed for the period.
Personal Tax Credits
Personal tax credits can reduce a taxpayer’s tax liability to zero but will not result in a tax refund (the credit will never exceed the tax liability). Examples of personal tax credits are child and dependent care credit, elderly and permanently disabled credit and education credits, such as the lifetime learning and Hope Scholarship credits.
Refundable Tax Credits
Refundable tax credits are deducted from the amount of income tax owed. It is possible for the credit to exceed the tax liability, even if taxes are not deducted from salary or wages. When the credit exceeds the tax, a tax refund will result. Examples of refundable tax credits are the child tax credit, earned income credit, withholding taxes (reported on a W-2 form) and excess Social Security paid.
Tax Credit Effect on Income Tax
The total amount of tax credits reduces the tax derived from taxable income plus any alternative minimum tax due. When taxable income and tax liability is increased by the earnings and profits from a shareholder’s investments, the use of tax credits will decrease the higher tax amount and diminish the effect of the increase in investment basis on taxable income.
- “Regulation: CPA Exam Review”; DeVry/Becker Educational Development Corp.; 2009
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