Earned Income Credit
The earned income credit (aka EIC, earned income tax credit, EITC) (IRC §32), enacted in 1975, is a refundable tax credit to lighten the burden of the regressive payroll taxes, which consists of the Social Security tax and the Medicare tax, on the poor. Hence, the credit can only be applied to earned income that is subject to employment taxes. So, for instance, it cannot be used to offset the taxes on unemployment compensation. The base amount of the credit depends on the number of qualifying children for which the taxpayer can claim as dependents, but the actual amount of the credit depends on the taxpayer's income. To claim the credit, investment income cannot exceed a limit that is adjusted annually for inflation.
The earned income credit is sometimes considered a negative income tax, because, being a refundable tax credit, it is paid to people even if they do not have a tax liability.
In previous years, many taxpayers took the EIC as an advance payment of earned income credit by reducing the tax taken out of their wages. However, this provision, which had been available for many years, was eliminated by the Education Jobs and Medicaid Assistance Act of 2010. IRC §3507, which authorized advanced payments, has been repealed. Hence, after 2010, the earned income credit can only be claimed with the tax return.
The earned income credit is available to single and married people with children. Taxpayers without children can also claim the credit if they are older than 24 and younger than 65 and no one else can claim them as a dependent. However, the earned income credit is larger for people with children and the phaseout limit is much higher.
Married persons filing separately may not claim the EIC. However, if a spouse lived apart from the other spouse for the last half of the tax year, then she may be able to claim the credit as head of household. Nonresident aliens cannot claim the credit, unless they are married and an election is made by the couple to subject their worldwide income to United States tax.
The amount of the earned income credit that can be claimed by the taxpayer depends on income and the number of qualifying children. A qualifying child must satisfy these tests:
- Relationship test: descendants of the taxpayer, stepson, stepdaughter, an eligible foster child, legally adopted child, half-brothers and half-sisters.
- Residency test: Taxpayer's principal place of residency must be located within the United States and the qualifying child must have lived with the taxpayer for more than ½ of the taxpayer's tax year. However, temporary absences are disregarded, such as for school, vacation, medical care, or detention in a juvenile facility.
- Age test: The child must be less than 19 years old at the end of the tax year, or 24, if the child is a full-time student. There is no age test for a child who is permanently and totally disabled at any time during the year. A person is considered permanently and totally disabled if he cannot engage in any substantial gainful activity because of the disability and a physician certifies that the condition is expected to last for at least a year or lead to death.
A child who is married by the end of the tax year, and who files a joint return, cannot be claimed as a qualifying child, unless the return is filed only to claim a refund.
If more than 1 taxpayer can potentially claim a certain child, then tie-breaking rules apply:
- If parents are living apart and filing separately, then:
- The parent with whom the child resided for the longest period during the tax year can claim the EIC.
- If there is no difference between the time periods, then the parent with the highest AGI has priority.
- A parent has priority over nonparents.
- When none of the potential claimants are the child's parent, then the person who had the highest AGI for the tax year has priority.
Earned Income, Disqualifying Income
The amount of the credit is limited by earned income, which includes:
- wages, salary, tips, commissions,
- union strike benefits,
- jury duty pay,
- certain disability pensions,
- self-employment earnings. For self-employed taxpayers, net losses are subtracted from wages or other income earned as an employee, if any.
Earned income does not include interest, dividends, alimony, welfare benefits, veterans' benefits, pensions and annuities, workers compensation, unemployment compensation, nontaxable employee compensation, excludable dependent care benefits, or excludable education assistance.
The earned income credit is not available if disqualifying income exceeds the investment income limit, which is adjusted for inflation annually. For 2013, the limit is $3,300. Disqualifying income includes:
- taxable and tax-exempt interest,
- rent and royalty income,
- capital gains
- passive income.
Presumably, a taxpayer with large amounts of unearned income does not need the EIC. The EIC cannot be claimed by a taxpayer who claims the foreign income exclusion, regardless of the amount.
How the Earned Income Credit Is Calculated
The earned income credit calculation is rather complicated, but most people can simply consult the EITC tax table in the instructions to Form 1040. If the taxpayer has qualifying children, then Schedule EIC should be filed with Form 1040 or Form 1040A, listing the qualifying children and their social security numbers. To calculate the EIC, taxpayers are classified into groups based on filing status and the number of qualifying children: 0, 1, 2, 3 or more.
The EIC calculation is based on the following numbers, which is stipulated by IRC §32, some of which are adjusted for inflation:
- Earned income amount: this is the lowest income that qualifies for the maximum credit.
- Credit percentage: for earned income which is less than the earned income amount, the taxpayer's income is multiplied by the credit percentage to yield the earned income credit.
- Phaseout amount: if the taxpayer's income is greater than this threshold, then the threshold phaseout amount is subtracted from the taxpayer's income to yield the phaseout base.
- The threshold phaseout amount is greater than the earned income base and is set by law, specifically IRC §32. Taxpayers with income between the earned income base and the threshold phaseout amount get the highest EIC available for their group.
- Phaseout percentage: the phaseout base is multiplied by the phaseout percentage, which is, then, subtracted from the maximum credit amount.
- If Income < Earned Income Amount, then
- EIC = Income × Credit %
- If Earned Income Amount < Income < Phaseout Amount, then
- EIC = Maximum EIC for the Taxpayer's Group, which is based on Filing Status and Number of Qualifying Children
- If Income > Phaseout Amount, then
- EIC = Maximum EIC – (Income – Phaseout Amount) × Phaseout %
- Therefore, the EIC is not available when the taxpayer's income becomes high enough, such that: (Income – Phaseout Amount) × Phaseout % ≥ Maximum EIC
(Married Filing Jointly)
|2014: Investment Income ≤ $3,350|
|3 or more||$6,143||$46,997 ($52,427)|
|2013: Investment Income ≤ $3,300|
|3 or more||$6,044||$46,227 ($51,567)|
|2012: Investment Income ≤ $3,200|
|3 or more||$5,891||$45,060 ($50,270)|
|2011: Investment Income ≤ $3,150|
|3 or more||$5,751||$43,998 ($49,078)|
|Source: Preview of EITC Income Limits, Maximum Credit Amounts and Tax Law Updates|
The maximum credit allowable phases out at much lower adjusted gross income (AGI) levels.
For taxpayers who are married filing jointly, the EIC begins to phase out with income greater than $21,800, for 1 or more qualifying children. However, the phaseout endpoint depends on the number of children. For all other taxpayers, the phaseout income begins at $16,700 for 1 or more qualifying children.
When there are no qualifying children, then the phaseout begins with an AGI of at least $7600 ($12,700 for married filing jointly) and the upper boundary for the phaseout interval is $13,660 ($18,740 for married filing jointly).
EIC Related Penalties
The IRS assesses penalties against taxpayers who fraudulently claim the EIC or flagrantly violates the rules. If the IRS sends a deficiency letter denying the EIC for a taxpayer, then the credit cannot be claimed in future years unless she files Form 8862. The taxpayer can claim the credit if the IRS re-certifies eligibility, in which case, Form 8862 does not have to be filed again unless the IRS denies the EIC again.
Future credits for a taxpayer are denied for 2 years if the taxpayer disregarded the rules in claiming the EIC. Fraud increases the period to 10 years.