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| The Basics | A great tax break that's hard to get
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The earned-income credit can provide a wonderful windfall. It also can be excruciatingly hard to understand, but it's well worth claiming if you qualify.
By Jeff Schnepper
If you dont earn a lot of money, you could qualify for one of the most valuable credits there is -- the earned-income credit. This is a credit, not a deduction. It reduces your tax, dollar for dollar.
But you dont even need to have a tax liability, or even much income to qualify. The earned-income credit is really a reverse income tax. Its what the tax professionals call a refundable credit. Because of your low income, the IRS is going to send you money.
The problem is that almost nobody knows how to navigate the complicated convolutions necessary to make the claim. It was a late night when Congress drafted this provision, and it shows.
I have an MBA in finance, two law degrees, am licensed by the New Jersey Board of Certified Accountants, have written over 30 books and more than 500 professional articles. Yet I still shiver when a client walks into my office claiming to qualify for the earned-income credit.
7 million errors
JoAnn Lane, of the Internal Revenue Services Wage and Investment Division, says 7 million of the 19 million returns claiming the earned-income tax credit in 2001 had errors.
As a result, according to a Brookings Institution study, many eligible taxpayers dont claim the credit and those who do lose a chunk of it to high preparation fees.
Congress drafted this tax code provision so poorly that if you have the education or finances sufficient to understand it (or hire someone who does), you probably cant qualify. Maybe that was the idea.
The earned-income credit has been in the tax code since 1975 and was set up to offset the burden of Social Security and Medicare taxes and to offer an incentive to work.
Money up front
It really is a nifty tax break -- if you can figure it out. And you can actually get the money in advance.
You can elect to receive advance payments of the earned-income credit from your employer rather than from the IRS. You make the election by filing a certificate of eligibility with your employer and by filing a tax return for the year the income is earned.
If you qualify, grab the money now. Otherwise, youre giving an interest-free loan to the IRS by allowing them to hold the dollars until you file.
How much you can claim depends on whether you have one, more than one, or no qualifying children. You multiply the appropriate credit rate by your earned income up to a given limit.
Sounds easy . . . but so does the big bang theory until you get into the physics.
Here are the parameters for 2005:
| To qualify for the earned-income credit in 2005 | | If you have | Then, your earned income (and AGI) must be less than: | Your maximum credit will be: | | No qualifying children | $11,750 ($13,750 if married and filing a joint return) | $399 | | 1 qualifying child | $30,030 ($33,030 on a joint return) | $2,662 | | 2 or more qualifying children | $35,263 ($37,263 on a joint return) | $4,400 |
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Here are the parameters for 2006:
| To qualify for the earned-income credit in 2006 | | If you have | Then, your earned income (and AGI) must be less than: | Your maximum credit will be: | | No qualifying children | $121,120 ($14,120 if married and filing a joint return) | $412 | | 1 qualifying child | $32,001 ($34,001 on a joint return) | $2,747 | | 2 or more qualifying children | $36,348 ($38,348 on a joint return) | $4,536 |
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So, what does all this mean?
A qualified child. Under 2005 rules, a qualifying child must meet three tests:- Relationship. The child can be your natural child or adopted child. The child can also be a grandchild, niece or nephew, brother or sister if you care for the child as if he is your own, or foster child.
- Age. The child must be under age 19 at the end of 2005.
- Residence. The child must have lived with you at least half of 2005.
You must provide the names, ages and Social Security numbers for all qualified children.
Disqualified income. Even if you meet all the criteria for children, you wont get the credit if you have too much disqualified income. Thats interest (both taxable and non-taxable), dividends, net rent and royalty income, net capital gains and net passive income thats not self-employment income.
If your net disqualified income is more than $2,700 in 2005 or $2800 in 2006, forget the earned-income credit.
Because this is a reverse income tax -- the IRS is sending you money -- its a provision ripe for misuse. The IRS has been inundated with erroneous claims. Some of them were honest mistakes; many were attempts by con artists to steal dollars from the Treasury.
In response, the IRS disproportionately challenges many claims for the credit. Thats fancy legal talk for auditing returns. When you read news articles attacking the IRS for disproportionately auditing low-income, rather than high-income, taxpayers, thats the reason. The government is looking for fraudulent earned-income credit claims.
Make no mistake
So, be really careful. Double-check your numbers.
If you take the earned-income credit and are found to be ineligible, you face severe consequences. If the IRS finds that your error was due to reckless or intentional disregard of the rules, you wont be allowed to take the credit for two years -- even if you would be otherwise eligible. If you fraudulently claim the credit, you wont be able to take it for 10 years.
The IRS really does want you to claim the credit, if you qualify. If you report dependent children on your return, and your income qualifies, they will actually send you a letter noting the availability of the credit.
The bad news is that the code provision is a quagmire of convolutions, exceptions and exceptions to the exceptions.
The good news is that if you provide the IRS with the appropriate income and qualifying individual information on Schedule EIC, the IRS will actually compute the credit for you. Assuming you provide the correct information, you cant be accused of wrongdoing if they do the computations.
For details on the earned-income credit, see IRS Publication 596 and Schedule EIC.
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