Improving the American Opportunity Tax Credit

Excerpt from Pub 970

In May 2024 I had the opportunity to participate in the California Lawyers Association Tax Section's DC Delegation. Participants identify a tax rule in need of reform and draft a paper explaining why change is needed and offer proposals for that reform.

My May paper was on modifying and clarifying the American Opportunity Tax Credit (AOTC) which offers up to $10,000 of tax credit (subsidy) to most families for a child (or themselves) in the first four years of college ($2,500 maximum credit for year for up to four years).

The phaseout income levels for the credit are quite high so at least 80% of families qualify.

But there is a bit of unneeded confusion and complexity in the provision including exactly how the "first four years of college" are determined. An example on the IRS website makes it sound like you can select which of the four years of college count which seems out of sync with Code Section 25A (Q&A 16).  But in sync if we are only required to ask if the student has reached "senior" status at the university. This basic issue should not be confusing, but is.

The IRS has an Interactive Tax Assistant tool on its website which can help but I found it might cause some users to give up such as asking if your spouse has an ITIN after answering "single" to the question about whether you are married.

There is also some complex planning possible if a student receives a scholarship, including a Pell Grant, that is partially taxable. One fix to help Pell Grant recipients has been proposed a few times but not enacted is to not require a Pell Grant recipient to reduce AOTC-eligible expenses by the amount of the grant.

For more background and my recommendations for both legislative and administrative improvements, see "Modify and Clarify the American Opportunity Tax Credit," Tax Notes Federal, 9/26/24.

What do you think?

American Opportunity Tax Credit Issues

Over the years, I have heard individuals and tax professionals raise various questions on the operation of the American Opportunity Tax Credit (AOTC at IRC 25A). This is the credit that for the past many years provides up to a $2,500 credit for each of the first four years of higher education at a college or university.  It started in the early 1990s as the Hope Scholarship credit for a lower amount and only the first two years of college.

There are numerous other tax breaks for higher education including an exclusion for scholarships, a limited above-the-line deduction for student loan interest, the Lifetime Learning Credit, an exclusion for interest on education savings bonds, 529 accounts, and more.

Some of the issues I have heard for the AOTC include:

• Do years at a community college count as part of the four years? I believe they do, but what if the student isn't, at least at first, pursuing a degree?
• What are all of the expenses that qualify?
• What if the 1098-T received (and required to claim the credit) is incorrect in terms of the year or amount?
• Why does it only cover college or university programs rather than also trade schools and similar?

I'm working on a paper of these and a few other administrative and legislative issues about the AOTC. If you have questions or issues you've encountered or wondered about, I would greatly appreciate you posting them in a comment here.  Thank you!

Common Sense and Tax Policy - Any Connection?

I think that often, there is some common sense consideration of tax policy before enacting or changing tax rules. One example was the 1954 decision to enact IRC section 174 to allow for expensing of R&D expenditures. That simplified the law to avoid uncertainties and taxpayer/IRS disputes on the life for amortization purposes of these expenses. It also incentivized these expenditures that also benefit the economy through new technologies to improve our lives. I'm sure we can find more recent examples too.

Of course, before leaving my example, I should note that the 2017 Tax Cuts and Jobs Act modified the R&D expensing rule starting after 2021 to require R&D expenditures to be capitalized each year and amortized over 5 years (15 years for foreign R&D).  That's an odd provision for a piece of legislation intended to improve international competitiveness of our tax system when most other countries have research incentives in their tax law, but oh well. (I think we'll see this rule forever postponed and hopefully repealed at some point to go back to expensing.)

I want to draw attention to the numerous places in our tax laws where tax breaks are provided for people who don't need them. By tax breaks, I mean provisions that are not part of the "normal" structure of a particular type of tax (such as a mortgage interest deduction in a personal income tax or an exemption for digital books in a sales tax). For example, the American Opportunity Tax Credit worth $2,500 of tax savings per college student per year for each of the first four years of college is available to taxpayers with up to $180,000 of income if married ($90,000 single). This is beyond the income level that would qualify for a needs based scholarship. So why provide a government subsidy to people who don't need it? (and that likely leads some colleges to increase student fees!) How might that money better help society and our economy by using the funds such as to increase the standard deduction and/or Pell grants?

There are many of these provisions in the law including the lower capital gains rate (20% maximum versus 37% maximum for non-capital gain income). One that I was reminded of recently in looking at updates for 2021 cars that qualify for perhaps up to a $7,500 credit for purchase of a new qualified plug-in electric drive motor vehicle (Code section 30D) is that the buyer of a MSRP $156,900 Bentley Motors Bentayga Hybrid SUV gets a $7,500 tax subsidy from the government - that is, all other taxpayers chip in a bit to help this buyer get the luxury car.

The credit exists to encourage car manufacturers to build electric and hybrid vehicles which they argue cost more so people don't want to buy them; hence, the tax credit. But what happened to common sense? If someone is able and willing to spend over $150K on a car, will their decision be based on whether the federal government will give them $7,500? I don't think so. The federal government with $27 trillion of debt is giving money to people who don't need it.  According to information on the donation website of one of my favorite charities - Sacred Heart in San Jose, $7,500 could instead provide 3,000 families with food including fresh fruit and vegetables for three days.  (Per the Bentley website, $7,500 would also help cover the cost of the $8,500 rear seat entertainment center for one's hybrid Bentley.)

How does this happen? How did this law get enacted years ago and remain unchanged without having a cap on the cost of the car?

What questions should we ask to help get government funds where they can provide the most benefit for our society and economy? 

A requirement that before voting on a bill, the "cost" of all new and modified tax breaks be published for at least two days could help. The "cost" information should also include how the new or modified rule will be used by taxpayers in each quintile of income plus the top 1% and top 0.1%. This statement should also include why the provision is needed and why it needs to be in the tax law. For example, the AOTC funding could instead be used for existing programs such as the longstanding Pell grant program. 

What do you think?

TCJA Expanded Preparer Due Diligence Beyond What Congress and IRS Highlight

The Tax Cuts and Jobs Act enacted December 22, 2017, included over 100 tax changes. In the discussion of tax reform, there was a possibility that the head-of-household filing status would be repealed for simplification purposes. But, it was kept. To try to reduce the errors in claiming this status, Congress expanded the Section 6695(g) preparer penalty to include application of the penalty to a paid preparer who does not exercise the appropriate due diligence in preparing a return where the client claims that status. The penalty is $530 per failure.

The Section 6695(g) penalty has gradually expanded since it was first enacted in 1997 to reduce errors in claiming and calculating the Earned Income Tax Credit by paid preparers. In 2015, Congress expanded the penalty to also possibly apply to a preparer who prepares a return where the client claims the Child Tax Credit (CTC) or American Opportunity Tax Credit (AOTC).

Congress and IRS have highlighted that the TCJA expanded the penalty to cover returns where the client claims head-of-household filing status. See for example, this November 7 news release (IR-2018-216). Well, the TCJA actually made this penalty potentially apply even more broadly! The TCJA temporarily repealed the personal and dependency exemptions. The dependency exemption was partly replaced with a $500 per dependent credit. Generally, this credit is available for your children over age 16 and under 19 (under age 24 is a full-time college student). It is also available to a qualifying relative. If a child is under age 17, the parent most likely gets a $2,000 credit for that child instead of $500.

The $500 credit is new and Congress put it in IRC Section 24 where the CTC is located. The Section 6695(g) penalty applies to "the credit allowable by section 24." So, the $500 dependent credit requires paid preparers to do extra due diligence to be sure the client is entitled to any such credit claimed. This basically means asking appropriate questions and documenting the questions and answers and maintaining this information and any documents received for at least three years after filing the return. Form 8867 must also be attached to the return.

Surprise!

What do you think?

Additional resources for Form 8867 and the Section 6695(g) preparer penalty:

• Section 6695
• Final regulations released in November 2018 (TD 9842 (11/7/18)
• Draft instructions for Form 8867
• Information from the California Franchise Tax Board on head-of-household status (California requires additional information on a return claiming this status due to potential for mistake)
• Due diligence for the EITC, CTC and AOTC (IRS Pub 4687) (let's see if this gets updated to address all items under Section 6695(g))
• AOTC - Pub 970 includes some helpful flowchart a preparer might want to have a client use to determine if they might be eligible for the AOTC

New Required Preparer Due Diligence for AOTC and Child Tax Credit

The addition of these two credits to the required due diligence of paid preparers in preparing a return that claims either or both was made by the PATH Act (P.L. 114-113, 12/18/15). The statutory language added at §6695(g) implied that regulations were needed. The IRS released draft Form 8867 and instructions in summer 2016, but did not release the regulations until 12/5/16. [TD 9799 (12/5/16) and REG 102952-16 (12/5/16)]

The regulations note that Form 8867 must be completed “and such other information as may be prescribed by the” IRS. The preparer must include relevant worksheets and Form 8863 and instructions (AOTC), or “otherwise record in one or more documents in the tax return preparer’s paper or electronic files the tax return preparer’s computation of the credit or credits claimed on the return or claim for refund, including the method and information used to make the computations.”

The regulations also include this rule about knowledge (§1.6695-2(b)(3)):

“(3) Knowledge—(i) In general. The tax return preparer must not know, or have reason to know, that any information used by the tax return preparer in determining the taxpayer’s eligibility for, or the amount of, any credit described in paragraph (a) of this section and claimed on the return or claim for refund is incorrect. The tax return preparer may not ignore the implications of information furnished to, or known by, the tax return preparer, and must make reasonable inquiries if a reasonable and well-informed tax return preparer knowledgeable in the law would conclude that the information furnished to the tax return preparer appears to be incorrect, inconsistent, or incomplete. The tax return preparer must also contemporaneously document in the files any inquiries made and the responses to those inquiries.”

Form 8867, lines 3 and 4, address the “knowledge” requirement. The instructions for these lines provide:

“As a paid tax return preparer, when determining the taxpayer’s eligibility for, or the amount of, a credit claimed on a return or claim for refund, you must not use information that you know, or have reason to know, is incorrect. You may not ignore the implications of information provided to, or known by you, and you must make reasonable inquiries if the information provided to you appears to be incorrect, inconsistent, or incomplete. You must make reasonable inquiries if a reasonable and well-informed tax return preparer, knowledgeable in the tax law, would conclude that the information provided to you appears to be incorrect, inconsistent, or incomplete. You must also contemporaneously document in your files any reasonable inquiries made and the responses to these inquiries.

You must know the tax law for each credit claimed on a return or claim for refund you prepare and use that knowledge to ask your client the right questions to get all the relevant facts to determine your client’s eligibility for the credit(s) and the correct amount of the credit(s).”

Here are a few questions I’d suggest are appropriate for determining if someone is eligible for the child credit (not a complete list).

• How old are your children? When were they born?
• Where do they go to school? What grades are they in?
• For a single parent, where does the child live? If the child lived the majority of the time with the parent who is your client, ask if he/she signed a Form 8332 to allow the other parent to claim the child.
• If a client tells you they have a signed Form 8332 from the other parent, ask if it has been revoked (did they receive notice of revocation from the other parent)?

A few questions for someone who appears eligible to claim the AOTC for their dependent child and whose income is below the phase-out range (also see Form 8863 and instructions, along with IRC 25A and information on the IRS website (regulations addressing AOTC are still in proposed form - REG-131418-14 (8/2/16)):

• When did they start college?
• How many units did they take each semester? (student needs to be at least a half-time student for at least one semester; also see Box 8 of Form 1098-T)
• Please provide me the Form(s) 1098-T the child received. If it shows amount billed rather than amount paid (see boxes 1 and 2), ask when the tuition was paid. You should also verify that the 1098-T is correct. Be sure Box 9 is not checked (student is a graduate student, indicating they are likely no longer in their first four years of collect).
• How much is the tuition?
• Did your child receive any scholarships or grants?
• Do you have a 529 or 530 plan for the child? (If yes, was it used?) Is the taxpayer/child eligible for other education tax benefits that may be more beneficial? Did they receive any tax-free education assistance from his/her employer?

Here are some tougher questions for the AOTC:

• Did you child receive academic credit for at least one semester of the tax year? This is a tough one as parents might not know the answer, particularly if the child dropped out after the refund period. Box 8 on Form 1098-T asks if the student was at least a half-time student. Perhaps that being checked is sufficient. Also, if not enrolled per how that term is defined at the university, a 1098-T likely should not have been issued. So, this might be a tough question if there is no 1098-T and the parent insists the child was in college during the year.
• Does the student have a felony conviction for possession or distribution of a controlled substance?

Perhaps it would be best to put these questions on a checklist for the client to complete and sign. It should include the reason why the question is asked.  You might want to refer clients to the AOTC information and flowcharts in Publication 970 and FAQs.  Also see IRS Pub 4687 with tips on due diligence for these three refundable credits.

The AOTC includes amount paid for books and related materials that are required by the university, even if not paid to the university. Before making any effort to determine these amount, see if the tuition paid for the year is high enough to max out the AOTC. In most cases, it will be (unless the student attends a community college in California). You max out the AOTC with $4,000 of tuition paid for the year (the credit is 100% of the first $2,000 and 25% of the next $2,000 for a maximum credit of $2,500).

The questions asked by the paid preparer and the answers/documents received from the client must be kept for three years after the return is filed. The Form 8867 is attached to the client’s return to avoid a $510 penalty to the preparer. Do note that even with the attached form, a preparer can still be subject to the penalty for not doing the required due diligence. This reminder is in the “what’s new” section of the Form 8867 instructions (although this is not new):

“Completing the form is not a substitute for actually performing the necessary due diligence and completing all required forms and schedules when preparing the return.”

I think the Form 8867 will help improve compliance with the child credit and AOTC as it will likely lead many preparers to review these credits in more detail and some may find that there were parts that they were not aware of before (such as that the AOTC is only for the first four years of college, even if that is only the first fall semester, if the student was at least half-time, that is a year of college). If a student attended a California community college for the first two years of college, parents might feel cheated because the tuition paid is not enough to max out the AOTC for those years (although books and other required materials, perhaps even a computer will help – see FAQ7). So, they might want to use the AOTC when the child transfers to a more expensive university, but it doesn’t work that way. The AOTC is only for the first four years of college. So, that parent (or student) doesn’t max out the AOTC, but they also aren’t paying a lot of tuition!

On a policy note, if a state university or college isn’t charging enough tuition to max out the credit, the California Legislative Analyst described this as the state giving a reverse subsidy to the federal government (that is, to students in other states). [See LAO’s February 1998 report]

Should the Form 8867 due diligence documentation requirement to avoid a penalty be expanded to other complex items claimed on a tax return? I don’t’ think so. Preparers already have required due diligence requirements such as the preparer penalty of §6694. Many preparers are also subject to licensing rules and those of professional organizations they belong to, as well as Treasury’s Circular 230. Congress likely expanded the §6695(g) penalty to these additional credits due to errors in claiming them. But, there are other solutions to address tax law complexity: (1) simplification, (2) required continuing education for all preparers (to address those not covered by licensing requirements for continuing education), (3) some assurance that paid preparers have adequate training including research skills and access to resources beyond IRS pubs and form instructions, and (4) due diligence checklists from the IRS to help preparers (and the IRS).

The PATH Act also requires the Treasury Department “to conduct a study evaluating the effectiveness of tax return preparer due diligence requirements for the EITC, child tax credit and AOTC. The study with respect to the EITC shall be completed one year from the date of enactment (December 18, 2015), and the study regarding the child credit and the AOTC shall be due two years from the date of enactment.” [JCT Bluebook to 2015 legislation, page 231]

The only study I find (at 12/24/16; 6 days after the 12/18/16 due date for the EITC report) is a 27-page report issued by Treasury in July 2016.  It addresses preparer due diligence, but doesn’t reference the PATH Act (only House Report 114-194). Per H. Rpt 114-194, the July report is tied to this request: “The Committee directs the Office of Tax Policy (OTP) and the IRS Office Research,  Analysis and Statistics to conduct data-driven analysis to  improve EITC compliance in collaboration with the tax  preparation community. Successful analysis will identify solutions effective for both paid preparers and self-preparers, ensure ease of taxpayer understanding. The Committee directs OTP and IRS to submit a report to the Committees on Appropriations in the House and Senate not later than six months after enactment of this Act on meeting this goal.” The report explains various initiatives the IRS used to improve EITC compliance (a subject for a future blog or article – looks interesting). So, it seems that we are still waiting for the §6695(g) EITC report due 12/18/16.

What do you think? (about the expanded due diligence for preparers for 2016 returns, preparer obligations in general, complexity, or anything else in this post)

Tax Day - April 15, 2014 - It Can Be Easier

The complexity of completing one's federal and state income tax returns is not necessarily tied to one's income level. One of the more complex federal tax rules is the Earned Income Tax Credit (EITC) for low-income workers. Could the individual income tax be simpler? Yes.  Here are some ideas.

• Make all income you received subject to tax. What is income? Let's say it is anything that increases your wealth. So, it would be any payment from the government, debt forgiveness, gross wages, employer-provided health insurance, scholarships, gains from selling assets, etc. What would not be income? Borrowing money (it does not increase your wealth because you have an offsetting liability). Receipt of expense reimbursements from your employer (it makes you whole for what you, in essence loaned to your employer when you incurred the expense).  The simplification comes from not needed to determine if something you received is taxable; generally, it would be.
• Allow very few non-business deductions.  It should just be personal and dependency exemptions that, in effect, remove from your income what it takes to live. The rationale is that you need some portion of your income to live and it should not be available for paying taxes. The amount should be tied to some multiple of the poverty level based on family size and your address to reflect that it costs more to live in some parts of the U.S. 
• Allow business deductions including an inflation-adjusted expensing amount (Section 179) that would provide simplification and incentives to small to medium sized businesses. Expensing should apply to both tangible and intangible personal property.
• Address equity issues with simple rules. For example, the state condemns your personal or business property resulting in you realizing a gain. But, you want to (or need to) buy replacement property. If you have to pay tax on the gain, you may not have enough for replacement property. So, keep a simplified Section 1033 on involuntary conversions that allows for gain deferral. Perhaps also allow for deferral of cancellation of debt income for insolvency or bankruptcy (to help with a fresh start for the person). The balance of the current, lengthy and complex cancellation of debt income exclusion rules could be removed. Others? There will be situations where someone has had some unusual, bad, expensive event, such as a casualty or large medical expense, that prevents them from having sufficient funds to pay their income tax. Some simple, limited rules for these types of events should be provided. We'd also need simple rules to ensure that income earned outside of the U.S. was not taxed by two countries. A foreign tax credit not to exceed what the U.S. tax on the income would be should work.
• Retirement plans and savings - this is a bit more challenging. Individuals should be saving for their retirement.  The money you put into your retirement is money not available for paying taxes.  Also, if you pay tax on the income when earned and again when withdrawn, that doesn't seem fair (except for what you pay on the income earned while the money was in the retirement account). Also, lower income individuals will need an incentive to fund a retirement account due to limited funds. So, should they get a deduction for putting funds in a retirement account?  Retirement rules is an area of our tax law in need of significant reform. The current rules primarily benefit higher income individuals as they can take better advantage of the rules. The rules are also complex due to the number of different types of retirement plans.
• Education incentives - today there are at multiple, duplicative, complex provisions offering various tax savings for higher education costs. I think that for the most part, this should all be taken care of outside of the tax law because there is already a system in place, such as for Pell Grants. When these rules are brought into the tax law, they primarily benefit those with enough income to owe tax - individuals who likely don't qualify for Pell Grants. But, what about my earlier point that the student receiving the scholarship will include it in income? Should they get some tax relief?  Or should we expect them to work to get the money to pay tax on the scholarship or seek a gift from family and friends?  Perhaps some version of the current American Opportunity Tax Credit (AOTC) should remain. It would also help the student without a scholarship or Pell Grant who is working to pay for tuition. It would not need to be refundable because once your tax is down to zero due to your personal exemption, you are not paying tax on the scholarship. Tax rules for higher education also need attention for simplification and equity issues. For example, the current AOTC is for the first 4 years of college, providing a maximum annual credit of $2,500.  That has differing results for these two students: (1) Ann who attends a private university for 4 years; gets a $10,000 benefit from the government. (2) Barbara who attends community college for 3 years where the annual tuition is less than the AOTC amount so she doesn't get full benefit of the credit and then she attends public university for 3 years to complete her degree and where the tuition is higher.  Her total benefit is less than $10,000.  This needs to get fixed.
• Other changes?  
• Lower tax rates to reflect that the tax base is larger with the above changes. With lower tax rates, capital gains should be taxed at those same rates. 
• The net investment income tax (3.8% Medicare tax for high income individuals) should be repealed (an adequately progressive income tax rate structure would take care of it). 
• AMT should be repealed because there should be only one minimum tax and removal of most of the special deductions, exclusions and credits would leave no need for it.
• Some replacement should be made for the current income exclusion for state and local bond interest income. This exclusion benefits higher income individuals who buy the bonds and it helps state and local governments. Whatever the average annual "cost" to the government has been for the exclusion for the past five years should become a fund that the federal government would make available to state and local governments to replace the lost benefit of the exclusion.  And add the caveat that they can only get the funds if they conform their state income tax to the new, simplified federal income tax system (to better ensure true simplification for individuals).
• More simplification such as fewer penalties and clearer rules on worker classification.

What do you think?

Opportunity vs. Hope vs. Reality - Tax Incentives for Higher Ed

The federal income tax law includes several incentives and subsidies for higher education expenses. The Hope Scholarship credit that has been around since 1997 was temporarily replaced for 2009 and 2010 with a more generous American Opportunity Tax Credit that applies to almost all taxpayers with higher education expenses because the AGI phase-out range is so high (ends at $180,000 for MFJ) and it applies to the first four years of college rather than just the first two under Hope.

President Obama has proposed making the AOTC a permanent replacement for the Hope Credit.

I've got a short article comparing these incentives against each other and against the reality of how long it really takes most people to finish college today and what it costs, as well as a critique of the AOTC using principles of good tax policy. You can find it here (AICPA Tax Insider, 7/15/10).

I'd like to see these incentives pulled from the tax law where they really don't work well. The funds aren't available when tuition is due, they provide benefits to many people who really don't need them while others struggle to get to and stay in college, the federal government already has various programs for helping students pay for college, and they complicate the tax law.

What do you think?