Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.

Ideas and information about planning for your family’s financial future

Should a parent or the student claim the American Opportunity Tax Credit?

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  • mike   

Did you know the American Opportunity Tax Credit (AOTC) can be claimed either on the income tax return of a parent or the student who is their dependent?

The AOTC is an important tax benefit to help defray education expenses of full-time college students.

The IRS has provided an explanation of Tax Benefits for Education in Publication 970, available at the IRS web site, www.irs.gov.

The credit is for the first $2,000 of qualified education expenses, plus 25% of the next $2,000 of expenses, or a maximum of $2,500 per year for the first four years of qualified post-secondary education. (The credit can’t be claimed for more than four tax years.)

The student must be enrolled at least half-time for at least one academic period that begins during the tax year, or the first three months of the next tax year when qualified expenses were paid during the previous tax year. The student must also be enrolled in a program that leads to a degree, certificate, or other recognized academic credential.

Only tuition and certain related expenses, including books, supplies and equipment needed for a course of study, are included in qualified education expenses for the credit. Room and board don’t qualify for the credit.

When a parent claims the AOTC, amounts paid by the student can be included to compute the credit on the parent’s income tax return. When a dependent child claims the AOTC, amounts paid by parent(s) can be included to compute the credit on the child’s income tax return.

Amounts reimbursed using tax-free funds, such as employer-paid expenses, tax-free scholarships, or tax-free distributions from Section 529 plans (qualified tuition arrangements), don’t qualify for the credit.

The AOTC is phased out when the taxpayer’s modified adjusted gross income (MAGI) is between $80,000 and $90,000 for single persons, or $160,000 and $180,000 for married taxpayers filing a joint return. Married persons who file a separate return and individuals claimed as a dependent by another taxpayer aren’t eligible for the credit.

The income of the parents might exceed the phaseout limitation, or a parent might file a separate return, so the parents might get no tax benefit from the credit. In that case, the student can claim the credit. (IRC Section 25A(f)(1)(A)(iii), Pub. 970, page 20.) The parent(s) may not claim the student as a dependent on their income tax return when the student claims the credit.

Since dependent exemptions have been repealed by the One, Big, Beautiful Bill Act (OBBBA), the main impact on the parents’ income tax return may be whether they can claim the child credit or the credit for other dependents. Since a child must be under age 17 to qualify for the child credit, it won’t apply for most college students. The credit for other dependents is $500 and phases out for married taxpayers who file a joint return with adjusted gross income exceeding $400,000 and other taxpayers with adjusted gross income exceeding $200,000.

40% of the AOTC is a refundable credit. Taxpayers who are subject to the “kiddie tax” aren’t eligible for the refundable credit, so most students who claim the credit on their income tax returns won’t get the refundable credit. (Mostly this applies when the student doesn’t provide more than half of his or her support. See the Instructions for Form 8615.)

Here are some additional rules to be aware of.

A person who qualifies as a dependent of someone else can’t claim himself or herself as a dependent. (A dependent student can’t claim himself or herself as a dependent, even when a parent doesn’t claim them as a dependent.) (IRC Section 152(b)(1).)

Accident and Health plans and HSAs are allowed for medical expenses of individuals qualifying as dependents, not based on whether the dependent exemption was claimed. (IRC Sections 105(b) and 223(d)(2)(A).)

The Kiddie Tax on unearned income of dependents still applies, because a parent is living. (Section 1(g).)

The standard deduction for 2025 is limited for a single person eligible to be claimed as a dependent to the greater of $500 or the sum of $250 plus the individual’s earned income, limited to $15,750. (IRC Section 63(c)(2) and (5).)

There might be state income tax considerations not discussed here for deciding whether to claim the AOTC on the federal income tax return of the parent or the student.

Families should determine whether claiming the AOTC on the federal income tax return of the parent(s) or the student provides the maximum tax benefit. Tax planning computations have become much more complicated under OBBBA. Consider using tax projection software that has been updated for the new tax law.

IRS issues rules for Roth 401(k) catch-up requirement

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  • mike   

On September 16, 2025, the IRS published final regulations relating to catch-up contributions to 401(k) and other elective contribution employer accounts. IR-2025-91. https://www.irs.gov/newsroom/treasury-irs-issue-final-regulations-on-new-roth-catch-up-rule-other-secure-2point0-act-provisions

The SECURE 2.0 Act of 2022 included some important changes for catch-up contributions to 401(k) accounts and other elective contribution employer accounts.

Effective for taxable years beginning after December 31, 2023, catch-up contributions by individuals who have $145,000 (subject to cost of living adjustments) or more of wages for the prior year could only be made to a Roth account, disallowing the exclusion from federal income taxes for that contribution.

In August, 2023, the IRS issued Notice 2023-62, which postponed the effective date for two years, until taxable years beginning after December 31, 2025.

The final regulations include the requirement that catch-up contributions for 401(k) plans must be designated as Roth contributions. Although the final regulations aren’t effective until taxable years beginning after December 31, 2026, the requirement in the tax law hasn’t been further postponed, so the requirement also applies for 2026.

Also note Roth contributions can’t be made unless the plan provides for them, so employees of companies whose plans don’t provide for Roth contributions can’t make catch-up contributions.

The catch-up contribution for employees who reach age 50 by the end of the tax year is generally limited to $7,500 for 2025, to be adjusted for inflation for future years. For taxable years beginning after 2024, plan participants who attain ages 60 through 63 have a higher catch-up contribution limit of 150% of the limit for other employees, or $11,250 for 2025, to be adjusted for inflation in future years.

The final regulations also include rules for other retirement plans, such as SIMPLE plans.

Employers and their plan administrators should meet with their tax advisors and legal counsel about updating their retirement plans for the new final regulations.

Small business stock gain exclusion planning

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  • mike   

Entrepreneurs creating new businesses have had an important benefit enhanced by the One Big Beautiful Bill Act of 2025 (OBBBA, H.R. 1, P.L. 119-21) – the Section 1202 Small Business Stock capital gain exclusion.  There are many tax planning considerations, including the choice of form of entity for the business, and employee stock option considerations.

Qualified Small Business Stock gain exclusion. 

Before the adoption of OBBBA, noncorporate taxpayers could exclude from taxable income capital gains from the sale or exchange of qualified small business stock held for more than five years.

Before the change, the exclusion was (still applies for qualified stock acquired before July 5, 2025):

  • 100% of the gain for qualified stock acquired after September 27, 2010;
  • 75% of the gain for qualified stock acquired after February 17, 2009 and before September 28, 2010; and
  • 50% of the gain for qualified stock acquired before February 18, 2009 (increased to 60% of the gain attributable to periods before 2019 if the stock was issued by a corporation in an empowerment zone and acquired after December 21, 2000.)

For stock acquired before September 28, 2010, 7% of the excluded gain is a tax preference item for alternative minimum tax reporting.

Excludable gain on dispositions of qualified stock from any single issuer for a tax year is limited to the greater of (1) $10 million, reduced by the aggregate amount excluded for the issuer’s stock in prior years ($5 million for married, filing separately); or (2) 10 times the taxpayer’s adjusted basis in all of the issuer’s stock disposed of during the tax years.

Gains on dispositions of qualified stock held by a pass-through entity for more than five years is passed through to partners, shareholders and participants who held interests in the entity when it acquired the stock and at all times thereafter.  The exclusion can’t reflect any increase in the person’s share of the entity after the entity acquired the stock.

In addition to the exclusion, taxable gains from sales of qualified stock may be deferred under Internal Revenue Codes Section 1045 by reinvesting the sale proceeds in stock of another qualified small business within 60 days after the sale.

Qualified small business stock is stock issued after August 10, 1993, and acquired by the taxpayer at the original issue, directly or through an underwriter, in exchange for money or property, or as compensation for services provided to the corporation.  The issuing corporation must be a domestic C corporation other than a regulated investment company, cooperative, or other pass-through corporation.

Both before and immediately after the qualified stock is issued, the corporation’s aggregate gross assets must not exceed $50 million, with parent-subsidiary controlled groups treated as one corporation.  During substantially all of the taxpayer’s holding period, at least 80% of the value of the corporation’s assets must be used in the active conduct of qualified trades or businesses.

A qualified business does not include the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business if its principal asset is the reputation or skill of employees.  Hospitality, farming, insurance, finance and mineral extraction also are not qualified businesses.

Note that retail, manufacturing, and research to develop a product are qualifying businesses.

How OBBBA changes the thresholds.

OBBBA changes the gain exclusion by creating tiers, effective for stock issued or acquired and to tax years commencing after July 4, 2025.  The exclusion ratios are 50% after three years, 75% after four years, and 100% after five years.  The per-issue dollar cap for post-enactment shares is increased from $10 million to $15 million reduced by the aggregate amount excluded for the issuer’s stock in prior years ($7.5 million for married persons filing separately), indexed for inflation after 2026.  The post-enactment aggregate-asset ceiling is increased from $50 million to $75 million, indexed for inflation after 2026. 

There is no alternative minimum tax preference for the excluded gains for these shares. 

The higher asset ceiling means the stock of more corporations will qualify for the exclusion. 

Shareholders who have capital gains from sales of qualified small business stock will be eligible to exclude more of their gains from taxable income.

The holding period requirement to qualify for a partial exclusion has been relaxed, so more sales of qualified small business stock will qualify for some exclusion from taxable income.

In the past, the thresholds haven’t been indexed for inflation.  Under OBBA, the thresholds will be automatically increased for inflation after 2026.

Family tax planning tip.

Giving family members cash to purchase qualified small business stock can increase the exclusion threshold for the family.  (Up to $15 million per family member.)

Choice of entity considerations.

Making a decision about what form a business should be requires having a long-term horizon and a crystal ball.

According to a Bureau of Labor Statistics report in 2024, about 20% of startups that opened for business in 2013 failed during the first year.  About 39% of startups failed within the first three years.  About 50% of startups failed within the first five years.  About 65% failed within the first ten years.  It seems the odds are against realizing a gain from the sale of startup stock.  Only a handful of shareholders do.

To qualify for small business stock to qualify for the exclusion, it must be issued by a corporation that qualifies when the stock is issued.  The corporation that issues the stock must be a regular “C” corporation (including an LLC that elects to be taxed as a C corporation – most don’t.)  Stock issued by an “S” (passthrough entity) corporation doesn’t qualify, but stock issued by a former S corporation after terminating its S election and becoming a C corporation can qualify.

Why is this important?

Business startups typically generate losses during their first few years.  Losses of a C corporation are “locked” in the business and aren’t deductible for its owners.  Losses of passthrough entities are eligible to be deducted on the income tax returns of their owners, subject to limitations like basis limitations, passive activity loss limitations, and at risk limitations.

Owners of general partnerships and sole proprietorships include their shares of “at risk” debt in their investment for the limitation for deducting business losses.  (If the business fails, they are liable for the debt.)

Passthrough entities aren’t subject to double taxation, like C corporations.  The owners pay income taxes on the entity’s taxable income and add that income to their tax basis (cost for computing taxable gain) for the sale of their ownership interest.

Partnerships and sole proprietorships have an advantage of being able to possibly liquidate by distributing their assets tax-free.

For businesses whose business plans don’t include having a public offering of their shares or selling the business at a multiple asset value for the foreseeable future, these are good reasons to choose passthrough structures, not C corporations.

For businesses that are adequately capitalized and are developing significant intellectual property or significant net income for a high multiple valuation that is expected to be sold soon after five years, or that plan to make a public offering of their shares, C corporations look more attractive.

Employee Stock Options and the Qualified Small Business Stock Capital Gain Exclusion.

The Ninth Circuit Court of Appeals has confirmed the Tax Court in holding employee stock options don’t qualify as stock for the Small Business Stock Capital Gain Exclusion.  The court also ruled the holding period of employee stock options before exercising them isn’t included for the 5-year holding period requirement.  The shares must be owned to start the clock.[1]

Any ordinary income for stock acquired by exercising an employee stock option isn’t eligible for the Small Business Stock Capital Gain Exclusion.

As explained below, determining when the holding period begins becomes complicated when employee stock options have a vesting schedule and the employer or other option granter permits an early exercise of employee stock options.  For nonqualified stock options, the employee may elect under Section 83(b) to treat the early exercise as taxable for regular tax and alternative minimum tax reporting.  When that election is made, the holding period starts on the date of exercise.  When that election isn’t made, the holding period starts on the later of the vesting date or the date of exercise.

For incentive stock options, the regular tax holding period starts on the date of exercise, regardless of vesting.  The Section 83(b) election to treat the early exercise as taxable only applies for the alternative minimum tax and the option is treated as a nonqualified option for alternative minimum tax reporting.  (The holding period might start on different dates for regular tax and AMT reporting.  Note there is no AMT adjustment relating to most Small Business Stock Capital Gain Exclusions.  For stock acquired before September 28, 2010, 7% of the excluded gain is a tax preference item for alternative minimum tax reporting.)

[1]Natkunanathan v. Commissioner, 110 AFTR 2d 2012-5193, July 12, 2012.

Should a surviving spouse roll over an inherited retirement account?

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  • mike   

When someone passes away is one time it's essential to consult with an estate planning lawyer, a tax advisor like a CPA or enrolled agent, and possibly a financial planner.

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Big Brother wants to watch EVEN MORE!

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  • mike   

Under the Notice of Proposed Rulemaking, transfers to a legal entity, including a TRUST, corporation, partnership, limited partnership or limited liability company, of residential real estate of up to four units and unimproved land zoned for occupancy by one to four families that don't involve financing through a financial institution would have to be reported on a Real Estate Report to FinCEN within 30 days or a sale or transfer, and copies kept by the reporting person and other parties for five years.

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Age 72 during 2023? You might get an extra IRA rollover

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  • mike   

If you received a scheduled required minimum distribution from an IRA because you reached age 72 this year, the IRS just gave you a "mulligan". (This relief also applies for a surviving spouse.) The IRS has announced you may roll the distribution back to the account no later than September 30, 2023.

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Michael Gray, CPA's Blog

Tax and financial advice from the Silicon Valley expert.