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Earned Income Tax Credit: Used, Abused and Altered

Article Highlights:

  • Purpose of the Earned Income Tax Credit
  • Qualifications
  • Earned Income
  • Qualified Child
  • Credit Phaseout
  • Computing the Credit
  • Investment Income Limit
  • Combat Pay Election
  • Fraud
  • Safeguards

Any discussion of the earned income tax credit (EITC) needs to begin with a discussion of why Congress created it in the first place. It has a twofold purpose: first, as an incentive for people to work and get off public assistance, and second, to provide financial assistance for low-income taxpayers and their families based upon their income from working, which the tax code refers to as “earned income.” When originally created back in 1979, it even allowed taxpayers to obtain the credit in advance through their employer’s payroll payments, based on projecting the credit they would be entitled to on their tax return for the year. This was referred to as advanced EITC. However, because of the many problems associated with the advanced payment credit, it was repealed for years after 2010.

The EITC is a refundable credit, meaning if any unused credit remains after offsetting all of a taxpayer’s tax liability, that remainder is refunded to the taxpayer. This refundable feature has made the EITC a giant target for fraud, which is discussed later in this article. In addition to the other requirements discussed below, the EITC is not allowed to married couples filing separately, nor can the taxpayer claiming the credit be a dependent of another taxpayer. In addition, the taxpayer must have been a U.S. citizen or resident alien all year and have a Social Security Number (SSN). Any children used to qualify the taxpayer for the credit are also required to have a SSN. Furthermore, because this credit is meant for lower-income individuals, if a taxpayer is working overseas and is able to exclude foreign earned income, he or she is barred from claiming the EITC. Taxable Earned Income – As previously mentioned, the EITC is based, in part, on the amount of a taxpayer’s (or in the case of a married couple, both a filer’s and a spouse’s) taxable earned income. For example, taxable earned income includes:

  • Wages, salaries, and tips;
  • Union strike benefits;
  • Long-term disability benefits prior to minimum retirement age; and
  • Earnings from self-employment.

Taxable earned income does not include any form of earned income that is excluded from income, such as a clergyperson’s housing allowance, excluded military combat pay (but see the election for combat pay later), tax-deferred retirement contributions, or excludable dependent care benefits.

Qualified Children – The EITC is also based upon the number of the taxpayer’s qualified children who lived with the taxpayer in the United States for more than half of the year for which the credit is being claimed. Generally, for EITC purposes, a qualified child must be younger than the taxpayer and be under the age of 19 or a full-time student under the age of 24 who had the same principal place of abode as the taxpayer for more than half of the tax year and is not married and filing a joint return (exceptions may apply).

For the EITC, “child” is defined as the taxpayer’s:

  • Son, daughter, adopted child, stepchild, eligible foster child, or a descendant of any of them (for example, a grandchild); or
  • Brother, sister, half-brother, half-sister, stepbrother, stepsister, or a descendant of any of them (for example, a niece or nephew).

Exceptions to the residency requirement include temporary absences from the home, such as for school, vacations, illness, and military service.

Computing the Credit and Phaseout – The amount of the EITC increases as the earned income increases until it reaches the maximum credit amount, and then it phases out as the taxpayer’s modified adjusted gross income (MAGI) increases above the phaseout threshold. The following table illustrates how the credit is determined and the maximum amount of the credit for 2019.

Number of Qualifying Children Credit Percentage Earned Income Maximum Credit
None 7.65 $6,920 $529
One 34.00 $10,370 $3,526
Two 40.00 $14,570 $5,828
Three or more 45.00 $14,570 $6,557

If a taxpayer has no qualifying children, the taxpayer must be age 25 or older but under the age of 65 before the end of the year. This is to prevent children and retired individuals from claiming the credit. As can be seen from the table above, the credit for a taxpayer who doesn’t have a qualifying child is significantly less than for someone with one or more children.

Example #1: Ted and Jane have two qualifying children, and their only income is Ted’s wages (earned income) of $31,738. From the table above, based on two children, we determine their EITC before the phase-out as being the lesser of $12,695 (40% of $31,738) or $5,828 (the maximum for taxpayers with two qualifying children). Thus, in this case, the EITC before phaseout is $5,828.

Phaseout – The tax law limits the EITC to lower-income taxpayers by phasing out (reducing) the credit as a taxpayer’s MAGI increases above a threshold, with the credit fully phased out when the MAGI reaches the complete phaseout amount shown in the table below.

Number of Qualifying Children Phaseout Percentage Phaseout Threshold Complete Phaseout
None 7.65 Joint Filers: $14,450
Others: $8,650
$21,370
$15,570
One 15.98 Joint Filers: $24,820
Others: $19,030
$46,884
$41,094
Two 21.06 Joint Filers: $24,820
Others: $19,030
$52,493
$46,703
Three or more 21.06 JointFilers:$24,820
Others: $19,030
$55,952
$50,162

 

Example #2: Using Ted and Jane fromexample #1, who have two qualifying children, we had determined that their EITC before phaseout was $5,828. The next step is to determine their credit after phaseout. We do that using the chart above, and for a married couple with two qualified children, the phaseout threshold begins at $24,820 and the phaseout percentage is 21.06%. Ted and Jane’s only income was Ted’s wages, so their MAGI is also $31,738. Their MAGI exceeds the phaseout threshold by $6,918 ($31,738 – $24,820). Multiplying that amount by the 21.06 phaseout percentage equals $1,457, which is the amount of the EITC that will be phased out. Thus, Ted and Jane’s EITC for 2019 will be $4,371 ($5,828 − $1,457).

Each year, the IRS develops credit look-up tables that take into account the taxpayer’s filing status, number of qualifying children, earned income, MAGI, and phaseout, so that the math we did in the above example is not needed.

Investment Income Limit – Congress further limited the credit so that taxpayers with substantial financial assets will not qualify for the credit. A taxpayer’s income from investments is used as a gauge for financial assets, and for 2019, taxpayers with investment income of $3,600 or more are disqualified from the credit.

Special Election for Combat Pay – Military members can elect to include their nontaxable combat pay as earned income for the credit. If that election is made, then the military member must include in his or her earned income all nontaxable combat pay received. If spouses are filing a joint return and both spouses received nontaxable combat pay, then each one can make a separate election.

Fraud – As mentioned earlier, the EITC is also a target of major fraud by unscrupulous tax preparers and ID thieves. In fact, the fraud has been so prevalent that the IRS has developed procedures, and Congress has passed tax laws, to combat the abuse.

One of the major areas of fraud was scammers filing returns with stolen IDs and phony income as soon as the IRS began accepting e-filed returns around the end of January. Filing early prevented the IRS from verifying the reported income because employers were not required to file W-2s and 1099s until the end of February. That also minimized the chances that the individuals whose IDs the fraudsters were using would file before them and cause the IRS to reject the return. In fact, many scammers would file married joint returns using the names and SSNs of two unrelated individuals, taking advantage of the IRS’s privacy policies; thus, if one of the victims contacted the IRS, the IRS would be unable to communicate with the individual because the victim would not know the name or SSN of the other filer on the bogus joint tax return. Of course, the income reported on the fraudulent returns was an amount meant to maximize the EITC and minimize the phaseout. The scammers also took advantage of the automatic refund deposit feature and had the refunds deposited into bank accounts that they opened in the names of the individuals whose IDs they were using on the fraudulent returns. Once the refunds were deposited into the accounts, the accounts were quickly cleaned out, leaving absolutely no trace of the scammers who were rarely caught. However, in a notable case in Florida, the scammer got away with millions of dollars in bogus credits and would not have ever been caught had she not bragged about her exploits online.

The IRS has since altered its return-processing procedures and plugged that hole, by not issuing refunds that include the EITC until after mid-February. The filing due dates for W-2s and 1099s have been moved up to January 31, giving the IRS adequate time to verify the earned income before issuing the refunds.

The IRS has also established the Identity Protection Specialized Unit to assist taxpayers who have been victims of ID theft. These taxpayers can file their returns by using an Identity Protection PIN provided annually by the IRS. Taxpayers who are or suspect they are victims of ID theft can call the IRS at 877-438-4338 for assistance.

Safeguards – Congress has also included consequences for taxpayers who have been found to abuse the EITC rules and has included mandatory taxpayer identification procedures for tax preparers.

  • Taxpayers – For taxpayers who recklessly or intentionally disregard the EITC rules, the IRS can make them ineligible for the credit in the two subsequent years, and if fraud is involved, the suspension period can be for ten years.
  • Tax Preparers – Tax preparers are required to follow mandated EITC due diligence procedures that require them to complete an EITC due diligence check sheet and verify the identity of anyone claiming the EITC before a return can be filed. Failure to adhere to these safeguards can result in a $530 tax-preparer penalty for each failure to comply with the due diligence requirements.

Many taxpayers who legitimately qualify for this credit are failing to claim it because they don’t fully understand the credit. For instance, the IRS estimates that 1.5 million taxpayers don’t realize that taxable long-term retirement benefits received before reaching minimum retirement age qualify as earned income, making them eligible for the EITC. The IRS also estimates that between 20 and 25 percent of the individuals who qualify for the EITC don’t claim it.

If you have questions about your qualifications for this credit or need help amending or filing a prior year’s return to claim the credit, please give us a call.

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