Earned Income Credit: new rules could ease qualification

Army Lawyer, June, 2002 by Curtis A. Parker

Earned Income Credit: New Rules Could Ease Qualification

Several changes to the Earned Income Credit (EIC) rules should reduce the confusion surrounding the EIC as well as increase the number of service members eligible for this valuable credit. The Economic Growth and Tax Reconciliation Act of 2001 (2001 Act) (1) changes the definition of earned income, (2) eliminates the use of modified adjusted gross income to measure eligibility for the EIC, (3) relaxes the definition of qualifying child, (4) and creates new rules for credit eligibility for persons with the same qualifying child. (5)

EIC: An Overview

In the case of an eligible individual, there shall be allowed as a credit against the tax imposed by this subtitle for the taxable year an amount equal to the credit percentage of so much of the taxpayer's earned income for the taxable year as does not exceed the earned income amount. (6)

The EIC is a refundable credit for working taxpayers whose income is below a certain dollar amount. (7) As a refundable credit, it not only reduces the amount of tax the taxpayer may owe, but also may provide a refund to the taxpayer in excess of his withholdings.

An eligible individual (8) is allowed a credit equal to the credit percentage times the amount of the individual's earned income for the tax year that does not exceed the statutory earned income amount. (9) For 2001, the EIC for a tax year could not be more than the excess of (1) the earned percentage of the earned income amount, over (2) the phase-out percentage of so much of the modified adjusted gross income (or if greater, earned income) of the individual for the tax year as exceeds the phase-out amount. (10)

Huh? If you are wondering what that last paragraph means, then you understand the need for simplification. The instructions for IRS Form 1040, the U.S. Individual Income Tax Return, contain ten pages of worksheets and tables necessary for determining eligibility and amount of the EIC. The Form 1040 instructions, a booklet only sixty-one pages long, dedicates thirteen percent of its material for calculating the entry for one line on Form 1040. (11) The time obviously was, and remains, ripe for simplification.

In general terms, the EIC is available to single or married people who work, either full- or part-time at some point during the year, depending on their income. Workers raising one child in their home and with family incomes of less than $28,281 in 2001 could get an EIC of up to $2428. Workers raising more than one child in their home and with family incomes of less than $32,121 in 2001 could get an EIC of up to $4008. Workers not raising children in their home who were between ages twenty-five and sixty-four on 31 December 2001, and had income below $10,710, could get an EIC of up to $364. (12)

To understand the EIC better, one must understand that it phases-in as well as phases-out. That is, to a point, the amount of credit for which the taxpayer qualifies increases as his income increases--phases in. The credit then levels out and remains level over a set income range. (13) Once the taxpayer's income exceeds this range, the amount of credit reduces as income increases, until the entitlement ceases--phases-out. (14)

The following examples illustrate calculation of the EIC under the pre-2001 Act rules:

Example 1. Corporal John Andrews and his wife Doris will file a joint return for 2001. They have two children--Mark who is age three and Connie who was born in May of 2001. Their total earned income is $23,650 (basic pay $16,104, basic allowance for housing (BAH) $4896, basic allowance for subsistence (BAS) $2650). John and Doris qualify for an EIC of $1779 in 2001. (15)

Example 2. Staff Sergeant Brad Wilson and his wife Judy will file a joint return for 2001. They have two children--Angela who is six years old and Eric who is four years old. Their total earned income is $34,054 (basic pay $25,140, which includes $7780 nontaxable pay for service in a combat zone, plus BAH $6264 and BAS $2650). Even though the Wilsons' modified adjusted gross income is $17,360, they do not qualify for the earned income credit because their total earned income is not less than $32,121. (16)

In 2002, however, there will be some changes.

Earned Income

Old Law. Before the 2001 Act, the Internal Revenue Code defined earned income as wages, salaries, tips, and other employee compensation, (17) and it included both compensation and self-employment income. (18) Such compensation included "anything of value received by the taxpayer from the employer in return for services of the employee." (19) The definition of earned income included compensation excluded from gross income as well as taxable compensation. (20) Nontaxable forms of compensation treated as earned income for EIC purposes included the following: (1) elective deferrals under a cash or deferred arrangement or annuity; (21) (2) employer contributions for nontaxable fringe benefits, including contributions for accident and health insurance, (22) dependent care, (23) adoption assistance, (24) educational assistance, (25) and miscellaneous fringe benefits; (26) (3) salary reduction contributions under a cafeteria plan; (27) (4) meals and lodging provided for the convenience of the employer; (28) and (5) housing allowance or rental value of a parsonage for the clergy. (29) For the military, it also included nontaxable combat zone pay and nontaxable housing and subsistence allowances received by military members. (30) Such amounts were included even if received in kind, for example, government quarters or furnished meals. (31)