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The new earned income credit.

The earned income credit (EIC) is designed to help low income taxpayers, who generally have not used professional tax preparers. For this reason, many tax practitioners are unfamiliar with the credit. However, Congress has amended Internal Revenue Code section 32 effective for 1991 tax returns. Among the changes is the addition of a separate form for computing the EIC; eligibility rules also have become more complex. Given this added complexity, and the increasing popularity of electronic filing of individual tax returns among taxpayers seeking quick refunds, more low income taxpayers entitled to the EIC are likely to seek help from professional income tax preparers.

EIC computation errors are one major reason why an electronically filed tax return is held up in processing or the direct deposit of a taxpayer's refund is changed to a check. Changing to a check can cause serious problems for a bank that has made a refund anticipation loan to the taxpayer; the refund goes directly to the taxpayer instead of into his or her account at the bank that made the loan.

For 1991, a new two-page form, schedule EIC, leads the taxpayer or preparer through the EIC computation. This article reviews EIC eligibility rules and provides a step-by-step guide for completing schedule EIC and calculating the credit.

EARNED INCOME

Earned income, for EIC purposes, can be substantially different from adjusted gross income (AGI) because of the omission of nonearned income items such as dividends, interest and alimony, and inclusion of nontaxable earned income, such as military housing and subsistence allowances. The computation starts with wages, salaries, tips, etc., on line 7 of form 1040 or form 1040A, but a number of adjustments may need to be made.

Reimbursed employee business expenses. Most employees incurring business expenses account to their employers by submitting expense reports; employers by submitting expense reports; employees are then reimbursed for the exact amount. If the employee is given a set amount per day for meals and lodging, he or she may be later required to submit actual expenses, and only any excess reimbursement is added to his or her W-2 form. In these cases, no adjustment to the amount on line 7 of form 1040 is necessary.

However, if the W-2 forms are incorrect, or the employer includes the entire reimbursement expecting the employee to deduct his or her business expenses on schedule A, an adjustment to the employee's earned income is necessary. Only employee business expenses deductible on schedule A, which have been reimbursed and included on lin 7, are subject to the adjustment.

IRC section 401(k) or cafeteria plans. Any contribution to an employer-sponsored 401(k) or cafeteria plan should be included in earned income. These amounts will not appear on the W-2 form in box 10 but may appear elsewhere on the W-2.

Other adjustments. Certain scholarships for which no form W-2 is received may no be earned income. Union strike benefits and certain disability pensions are includable in earned income, although not taxable.

Military quarters and subsistence. Military personnel basic allowances for quarters (BAQ) or for subsistence (BAS) do not appear on the tax return because the amounts are not taxable. The fair market value of any housing, food and other allowances given to military personnel should be added when computing earned income. In some cases, the taxpayer may have to estimate the value of the apartment or other quarters or allowances being provided.

To be eligible for the EIC, the law requires the taxpayer maintain a home in the United States and have a qualifying child living in that home. Thus, military personnel living abroad are not eligible for the EIC if the child is also living abroad.

Self-employment. The computation of net earnings from self-employment may be different for purposes of computing earned income for the EIC from that for computing income subject to self-employment Social Security taxes. If the taxpayer uses the optional method of figuring net earnings from self-employment, this amount must be included in earned income.

CREDIT VARIABLES AND ELIGIBILITY

Eligible individuals. An eligible individual is one who has lived with a qualifying child for the required period of time during the year. The eligible individual cannot be

* A qualifying child. (In other words, someone who qualifies someone else as an eligible individual cannot take the EIC.)

* A person filing as married filing separately.

* A taxpayer claiming benefits under IRC section 911, relating to citizens living abroad.

Number of children and age. The basic credit varies depending on whether the taxpayer has one or two qualifying children and whether one is under age one at December 31 of the taxable year. Thus, the taxpayer may have

A. One child who was age one or more on December 31.

B. Two children, both age one or more on December 31.

C. One child who was born in 1991.

D. Two children, at least one of whom was born in 1991. Having more than two children does not increase the EIC.

There is also a health insurance credit (HIC), which is computed separately and added to the basic credit.

DEFINITION OF QUALIFYING CHILD

The requirements for a qualifying child are listed in a questionnaire developed by the author, in exhibit 1, above, and are explained in greater detail here.

Residence, relationship and taxpayer filing status. If the child is related to the taxpayer by blood or adoption or is a stepchild, the law requires the qualifying child to live in the same household as the taxpayer for more than six months of the tax year. A foster child (one whom the taxpayer cared for as his or her own child) is required to have lived with the taxpayer for the entire year.

The taxpayer's filing status is ignored, except married-filing-separately taxpayers are not eligible for the EIC. Single filers, not eligible under prior law, now may be eligible. However, the credit cannot be claimed on form 1040EZ.

A descendant of a son or dauther is now included in the law as a qualifying child. A legally adopted child or a child placed with the taxpayer for adoption by an authorized placement agency is treated as a child by blood. Thus, only a descendant of a stepchild is not included.

Age. There is also an age requirement, whether the hicld is married or not. On December 31 of the tax year, the child must be one of the following:

* Under age 19.

* Under age 24 and a full-time student during five calendar months of the tax year.

* Any age and permanently and totally disabled.

Dependency. Regardless of the eligible individual's filing status (except for married filing separately), a married qualifying child must be the taxpayer's dependent or be exempted under the rules for children of divorced or separated parents. A married qualifying child also must not be filing a joint tax return. Thus, a married qualifying child must have a filing status of married filing separately or must not be filing a return at all. The only exception to the filing status rule may be where a joint return is filed as a refund claim under IRS revenue ruling 65-34, 1965-1 CB 86. (A discussion of that apparent exception to IRC section 151(c)(2) is beyond the scope of this article.)

Note: Just because a child meets the requirements of a dependent under IRC section 152 does not necessarily mean an exemption will be allowed. Even though a person is legally married, he or she may be considered unmarried for income tax purposes if certain tests under IRC section 7703 are met. An unmarried child need not be the taxpayer's dependent to be a qualifying child.

Support test. The law does not require any support test for an unmarried child. Thus, a married couple filing a joint return, or a single filer, is eligible for the EIC if the qualifying unmarried child meets the age and relationship requirements and lived with the taxpayer for more than six months of the year, even though someone else supported the child, such as a prior spouse.

A head of household is required to have furnished more than half the household's support, but not necessarily more than half the support of an unmarried child. A qualifying widow(er) with a dependent child, of course, must support the dependent child more than 50%.

COMPUTATION OF THE EIC

Computation of the EIC is illustrated in exhibit 2, at right. The letters A, B, C and D refer to the four situations described on page 68; the amount of the credit depends on whether the taxpayer has one or two children and whether one was born in 1991. The HIC is in addition to the basic credit.

On schedule EIC, if AGI is less than $11,250, the taxpayer needs to look up in the table provided in the instructions for form EIC only the amount of his or her earned income to find the credit. However, if AGI is $11,250 or more, the taxpayer is sent to the table twice--once to find the credit on earned income, and again to find the credit based on AGI. The taxpayer then enters the smaller of the two amounts.

Actually, the only time it is necessary to look up to amounts in the table is when earned income is less than $7,140 and AGI is more than $11,250. If neither earned income nor AGI exceeds $11,250, the taxpayer need use only earned income. If either earned income or AGI, or both, exceed $11,250 and earned income exceeds $7,140, the taxpayer carries the higher of earned income or AGI to the table to calculate the EIC.

To find any HIC, it is not necessary to look up two amounts in the HIC table. The amount of earned income or AGI used to find the basic credit should be used here. However, the HIC cannot be more than the taxpayer paid for health insurance. Instead of using the tables provided, the basic credit and HIC can be computed directly by using the formulas in exhibit 3, page 71.

CORRELATION WITH OTHER FORMS

The law provides for interaction between segments of the new EIC and other deductions the taxpayer is allowed.

Child care credit. If the additional EIC for a child born in 1991 is taken, the expenses of caring for that child cannot be used on form 2442 to compute the child care credit. Thus, the taxpayer who wishes to list on form 2441 the child care expenses for a child under age one can still take the EIC provided for in IRC section 32(b)(2) but cannot take the additional credit for a child born in 1991. Conversely, the taxpayer can take the additional credit if the expenses for the child under age one are not included on form 2441.

If the taxpayer's employer has child care plan under IRC section 129 and the taxpayer elects to include child care expenses for a child under age one, the taxpayer cannot take the additional EIC for that child.

Thus, where the taxpayer has a child born in 1991, the tax preparer must compute the child care credit, and the exclusion for employer-provided child care benefits, if applicable, both with and without the qualifying expenses for this child. Under these circumstances, the preparer also must compute the EIC with and without the supplemental credit for the child born in 1991.

The preparer should then complete page 2 of the form 1040 or 1040A using each of the above alternatives to see which benefits the taxpayer more. Remember, the EIC is a refundable credit, while the child care credit can only be used against tax due.

The law does not specify the options for a taxpayer who has two children under age one at December 31, for example, twins or children from two different families. Presumably, the taxpayer could list the child care expenses of one child on form 2441 and still use the EIC amount for the other child under age one at December 31, 1991.

Medical expenses. A taxpayer who takes the HIC must reduce the health insurance premium included in medical expenses as an itemized deduction by the amount of the credit. (See discussion below for self-employed persons.)

Self-employed health insurance deduction. On line 26 of form 1040, a self-employed person is allowed to deduct 25% of health insurance premiums. The remaining 75% may be deducted as a medical expense (above the 7.5% floor). However, if the taxpayer also takes the HIC, several complicated adjustments must be made.

A self-employed person who has paid for health insurance will have to compute a special AGI to be used on schedule EIC. For purposes of computing the EIC, AGI will be the taxpayer's AGI after deducting the full 25% health insurance deduction, without reduction by the health insurance EIC. However, the amount entered on line 26 of form 1040 must be 25% of the health insurance cost less 25% of the HIC.

As a result, the AGI on schedule EIC will not match line 31 of form 1040. If the self-employed person also takes a medical expense deduction, that deduction must be reduced by 75% of the HIC.

COMPLICATIONS WITH JOINT RETURNS

The law is silent on the situation of a joint return where only one spouse is an eligible individual for EIC purposes. For example, assume Joan is divorced with a two-year-old son, John. On December 20 she marries Richard. Joan has earned income for the year of only $2,000, having lived mostly on child support. Richard has earned income of $10,000. Joan and Richard file a joint tax return for 1991. Although Richard lived only a few days with John, it appears that on the couple's joint tax return the EIC can be taken on Richard's income as well as on Joan's. Thus, on a joint return, if either spouse is an "eligible individual," the total earned income or AGI on the return is used in computing the EIC.

The sidebar on pages 72-73 provides six additional situations illustrating different aspects of the new EIC rules.

FINE TUNING

As this article has demonstrated, the new EIC rules need some fine tuning. A number of amendments to the law are being suggested:

* Repeal the interaction between the EIC and the child care credit and between the medical expense deduction and the self-employed health insurance deduction.

* Codify the apparent rule that only one eligible individual is needed on a joint tax return.

* Base the EIC eligibility test on the higher earned income rather than the taxpayer's AGI, where one qualifying child makes two individuals eligible for the EIC.

One certainty is taxpayers are likely to find the EIC rules more complicated than before. And even tax practitioners may find they have questions on how to perform the difficult computations needed to determine the credit.

ROBERT E. NELSON, CPA, JD, is an attorney and senior law partner of Nelson & Schmeling, Green Bay, Wisconsin. He also is president of Nelco, Inc., a company that develops tax preparation products.
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Title Annotation:includes illustrations of new EIC rules
Author:Nelson, Robert E.
Publication:Journal of Accountancy
Date:Jan 1, 1992
Words:2512
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