Earned Income Credit

2022-11-13The 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 is only available to those with earned income that is subject to employment taxes. So, for instance, if you received only unemployment income for the year, you will not qualify for the EIC. The base amount of the credit depends on the number of qualifying children for which the taxpayer can claim as dependents, and 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 IRC §3507, which authorized advanced payments, has been repealed.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.

Some states also have an EIC. Vermont, for instance, has one of the most generous earned income credits. The average EIC recipient received about 25% of their total EIC from Vermont. States may also have different requirements. Vermont, for instance, requires a taxpayer to have at least 1 child, be between ages 25 and 65, receive income from work, and live in a low-income household. So, a low-income wage earner who lives in a middle-class family would not qualify.

The primary advantage of the EIC is that it is the best tax break for reducing poverty. While many politicians espouse a higher minimum wage to combat poverty, thereby making labor more expensive and employers more inclined to use automation to reduce labor costs, the EIC is only paid to poor families, at no cost to employers.

Eligibility

The earned income credit is available to single and married people or a head of household with children. Taxpayers without children may 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. However, if the taxpayer has children, then they must claim a filing status as head of household, married filing jointly, or as a qualified widow(er) to claim the EIC. If the children are not qualified only because they do not have valid Social Security numbers, then the taxpayer can claim the EIC without children if she would otherwise qualify.

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 or if legally separated or under a decree of separate maintenance and the spouses did not live together at the end of the tax year, then a spouse with a qualifying child who lived with the taxpayer for more than half of the tax year may claim the credit as head of household even though her filing status is married filing separately. 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. For head of household and filing married jointly, a qualifying child must satisfy these tests:

• Relationship test: descendants of the taxpayer, stepson, stepdaughter, brother or sister, stepbrother or stepsister, half-brother or half-sister, or any of their descendents, an eligible foster child, or legally adopted child.
• 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.

The rules differ slightly for qualifying surviving spouse (QSS). The qualifying surviving spouse (QSS) status differs from the head-of-household status by not counting foster children as qualified dependents under this provision and by requiring that the child must have lived with the taxpayer for the entire year instead of just more than ½ year required for head-of-household status.

Taxpayers ineligible for the EIC because their children do not have Social Security numbers valid for employment may claim the childless EIC.

You must identify your children on Schedule EIC, Earned Income Credit, Qualifying Child Information. This form will also walk you through the steps for determining if your children are qualified for the earned income credit.

Tie-Breaking Rules

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.

If you cannot claim the child because of the tie-breaking rules, then you may still claim the childless EIC, if you would otherwise qualify.

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,
• net earnings from self-employment earnings minus 50% of the self-employment tax. 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 (listed in the table at the top of this page), which is adjusted for inflation annually. Disqualifying income includes:

• taxable and tax-exempt interest
• dividends
• 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, based on both earned income, the income earned from work, and adjusted gross income (AGI), but most people can simply consult the EIC tax table in IRS Publication 596, Earned Income Tax Credit. If the taxpayer has qualifying children, then Schedule EIC should be filed with Form 1040, 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, stipulated by IRC §32, some of which are adjusted for inflation:

• Credit Base: this is the income that qualifies for the maximum credit.
• Credit percentage: for earned income which is less than the AGI, the taxpayer's income is multiplied by the credit percentage to yield the earned income credit.
• Phaseout amount: if the taxpayer's earned income or AGI, whichever yields the lowest credit, exceeds this threshold, then the threshold phaseout amount is subtracted from the taxpayer's income to yield the phaseout base.
• The threshold phaseout amount exceeds 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.

To summarize:

• If Earned Income < Credit Base, then
  • EIC = Earned Income × Credit %
• If Credit Base  <  Earned Income < Phaseout Amount, then
  • EIC = Maximum EIC for the Taxpayer's Group, which is based on Filing Status and Number of Qualifying Children
• If Total Income > Phaseout Amount, then
  • EIC = Maximum EIC − (Total 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

This is how the earned income credit is calculated according to the EIC worksheet found in IRS Publication 596, Earned Income Tax Credit.

1. Enter your earned income, the income earned from work.
2. Look up the EIC from the table for that amount.
3. Enter your adjusted gross income (AGI) from Form 1040.
4. If your AGI is less than a certain amount (2021: $11,650 ($17,600 for married filing jointly) for no qualifying children, $19,550 for 1 or more qualifying children, or $25,500 if married filing jointly), then your credit depends only on your earned income. The reason for this special rule is to ensure that if you make a contribution to your retirement account or Health Savings Account or you claim a deduction, such as student loan interest, which will lower your AGI, it will not also lower your earned income credit, if your income is before the peak EIC.
5. Otherwise, your credit = the lower of the credit based on your earned income or the credit based on your AGI.

As can be seen in the above graph, the maximum credit allowable phases out at much lower adjusted gross income (AGI) levels.

This chart shows a graph of the earned income tax credit for taxpayers with no children, with 1 child, with 2 children, and for 3 or more children, based on the values from the 2021 IRS Publication 596, Earned Income Tax Credit, clearly showing how the EIC changes with income.

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.

Historical Notes

• Because of the Covid-19 pandemic, the new Consolidated Appropriations Act for 2021 (H.R. 133), signed into law on December 27, 2020, allows taxpayers to substitute 2019 earned income for 2020 earned income for both the Earned Income Tax Credit and/or for the Additional Child Tax Credit, if it is advantageous to do so, but this substitution may not be used to calculate any other tax items, such as gross and taxable income. Spouses filing jointly must make the same election. If the taxpayer elects to use nontaxable combat pay, then the 2019 rather than the 2020 nontaxable combat pay should be used to calculate the credit.