The Earned Income Credit - Part II

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The Earned Income Credit, Part II
Limitations and Exceptions

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By Roy Lewis

In Part I, we discussed some of the general requirements and restrictions associated with the Earned Income Credit (EIC). Take a few minutes to go back and review that article for your basic background information. You'll see how complicated it can really be.

[As we noted in Part I, all of the income limitations related to the EIC, and the credit amounts qualified people will receive, are indexed for inflation -- so they change each year. We are listing amounts for tax year 2000, so be sure to double-check amounts for any other tax year you're looking at.]

And... speaking of complicated... let's move on to some definitions.

Investment Income Limitations

We previously noted that, to qualify for the EIC, your investment income in 2000 cannot exceed $2,400. For the purposes of this discussion, investment income includes:
  1. Taxable interest and/or dividends
  2. Tax-exempt interest
  3. Net income from non-business rents and royalties
  4. Net capital gain reported on Schedule D
  5. Net passive income
So, while it is very possible that your total earned income is low enough to qualify for the EIC, your excess investment income alone can make you ineligible.

Example: In tax year 2000, John has a qualifying child for EIC purposes, and has earned income of $15,000. John also has net capital gains of $2,500. Because of this excess investment income, John is not eligible for the EIC. John's total income is only $17,500 -- well under the Adjusted Gross Income (AGI) limitations -- but, since his investment income was over the $2,400 limit, he loses his entire eligibility for the EIC. So, keep this little fact in mind if you might otherwise qualify for the EIC, but have other income from investments.

Earned Income Defined

For purposes of the EIC, earned income includes all income from employment... even if the income is not taxable. Taxable earned income would include:
  • Wages, salaries, and tips
  • Union strike benefits
  • Long-term disability benefits received prior to your minimum retirement age
  • Net earnings from self-employment
Non-taxable earned income would include:
  • Voluntary salary deferrals (deferred compensation)
  • Voluntary salary reductions (cafeteria plan)
  • Combat zone pay
  • Basic and in-kind quarters/subsistence allowances from the U.S. military
  • Meals or lodging provided by an employer for the convenience of the employee
  • Housing allowance or rental value of a parsonage for the clergy
  • Excludable dependent care benefits
  • Anything else of value (money, goods, or services) for services performed, even if not taxable
Remember, when dealing with the EIC rules, earned income can include more than just your "normal" W-2 wages.

Modified Adjusted Gross Income

I decided to leave one of the most complicated provisions for last, and that's the definition of modified AGI. For EIC purposes, modified AGI would begin with your normal AGI, as reported on your tax return, plus all of the following:
  1. Your net capital loss from line 13 of Form 1040
  2. Any net loss from estates and trusts that you normally report on page two of Schedule E
  3. 75% of the net loss from non-farm sole proprietorships from line 12 of Form 1040
  4. 75% of the net loss from farm sole proprietorships from line 18 of Form 1040
  5. 75% of the net loss from other trades or businesses reported on Schedule E
  6. Net loss from non-business rents and royalties reported on Schedule E
  7. Tax-exempt interest
  8. Non-taxable distributions from pensions, annuities, and IRAs (except for a rollover or trustee-to-trustee transfer of an IRA or other retirement plan)
So, if you have a complicated return, you'll have to take a close look at how all of the numbers are assembled to determine your correct modified AGI.

Computing the Credit

Well... perhaps the definition of modified AGI isn't really the most complicated issue to deal with for the EIC. If you read the law, trying to compute your EIC is a real head scratcher. There are separate rates, and AGI limitations, and percentage limitations, and phase-out limitations. If you had to do these computations by hand, you would likely arrive at the wrong answer most of the time.

But, the IRS realized this early on and provided an all-inclusive table. This table, along with the IRS worksheet that you must use to compute the EIC, will make the process as painless as possible. Without the EIC worksheet and the EIC tables, computing the credit would be next to impossible. These can all be found in IRS Publication 596 (the tables are in the Appendix).

Once you complete the worksheet, you go to the tables and look up your EIC. It will be anywhere from a low of $1 to a high of $3,888 for tax year 2000, depending on your personal situation, number of qualifying children, etc.

If all else fails, you can even have Uncle Sammy compute the credit for you if you provide him with the necessary information, as noted on the EIC worksheet.

One Final Thought

We know that none of the Fools reading this would ever try to pull the wool over the eyes of the IRS and claim the EIC when they are not eligible. But, sadly, many people do. The IRS has determined that the EIC has been tremendously abused. It's easy to do... virtually anybody with larceny in his or her heart can. Because of that potential, the IRS has imposed some pretty tough penalties for those who decide to play fast and loose with the rules.

Fraud: Any taxpayer who fraudulently claims the EIC is disqualified from claiming the EIC for the next 10 years. This is in addition to any criminal prosecution the IRS may try to take.

Reckless or Intentional Disregard for the Rules: Any taxpayer who improperly claims the earned income credit with a reckless or intentional disregard for the rules is disqualified from taking the credit for the next two years. Intentional disregard does not mean a minor math or clerical error. If your credit is denied simply for a minor math or clerical error, you don't have to live in fear of this provision being enforced against you.

Denial/Reinstatement: If you are denied the EIC under either of the two provisions, you must apply for reinstatement by filing IRS Form 8862 "Information To Claim Earned Income Credit After Disallowance."

Due Diligence for Tax Preparers: Tax preparers are also under the gun. Under the Taxpayer Relief Act of 1997, a $100 penalty is imposed on any preparer who fails to meet "due diligence" requirements regarding the EIC. The IRS has issued procedures that tax preparers must follow to protect themselves from the penalty. So, if you decide to take your return to a tax preparer, don't be surprised if s/he asks you a number of pointed questions to shield themselves from any potential penalty.

Are the rules complicated? Sure. Are they too complicated for the people they are designed to benefit? We believe so. Is the IRS trying to do its best to give the credit to as many qualifying individuals as possible? Absolutely. But, there are some difficult complications and some concepts and rules that may be difficult to understand. We hope that by highlighting the issues surrounding the EIC you'll be able to more clearly understand the problems... and the solutions.
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