Applications and Due Diligence of the Earned Income Tax Credit Developed by Raven Deerwater, EA, PhD CSEA President Palomar Chapter December 19, 2012 Raven Deerwater EA, Ph.D has a tax practice in Mendocino, California, specializing in individuals and families. A former math teacher and professor, Raven wrote the lead article The Do s of Due Diligence for the May-June 2010 issue of the EA Journal. He is currently the President of CSEA for 2012-2013.
TABLE OF CONTENTS Description of the Course... 1 Objectives of the Course... 1 Opening Scenario... 1 Eligibility for Earned Income Tax Credit... 2 Part A. Rules for Everyone... 2 Rule 1. AGI and Earned Income Limitations... 2 Rule 2. Taxpayer Must Have a Valid Social Security Number... 2 Rule 3. Taxpayer s Filing Status Cannot Be Married Filing Separately... 2 Rule 4. Taxpayer Must Be a U.S. Citizen or Resident Alien All Year... 3 Rule 5. Taxpayer Cannot File Form 2555 or Form 2555-EZ... 3 Rule 6. Investment Income Limitation... 3 Rule 7. Taxpayer Must Have Earned Income... 3 Part B. Rules to Determine a Qualifying Child... 4 Rule 8. Relationship, Age, Residency, and Joint Return Tests... 4 Rule 9. Only One Taxpayer Can Claim Any Individual Qualifying Child... 5 Rule 10. Taxpayer Cannot Be a Qualifying Child of Someone Else... 6 Part C. Rules if There is No Qualifying Child... 6 Rule 11. Taxpayer Must Be at Least Age 25 but Under Age 65... 6 Rule 12. Taxpayer Cannot Be a Dependent of Someone Else... 7 Rule 13. Taxpayer Cannot Be a Qualifying Child of Someone Else... 7 Rule 14. Taxpayer Must Have Lived in the U.S. More Than Half the Year... 7 Common Misconceptions... 7 Worked Opening Scenario... 8 EITC Due Diligence... 9 Common Errors... 9 Requirements of Paid Preparers... 10 Best Practices... 10 Know the Law... 11 Get the Facts... 11 Ensure Income is Reported Correctly... 11 Document the Responses... 12 Related Resources... 13 i
Description of the Course This course will cover different aspects of the Earned Income Tax Credit (EITC). There will be a basic description of the credit followed by a demonstration of who qualifies to take the credit through examples of many different family configurations. This presentation will also touch on some of the disqualifications of the EITC. Also included will be a full discussion of the due diligence requirements of tax preparers who prepare a tax return containing the EITC. Since EITC fraud is widespread, preparers must take precautions in preparing these returns. Objectives of the Course Understand the 14 rules determining eligibility for the EITC. Apply the 14 rules determining eligibility for the EITC in many different situations. Be aware and comfortable with questions you need to ask clients when there is a potential EITC claim. Understand the IRS recommended Best Practices for Due Diligence of practitioners who sign returns that include the EITC. Opening Scenario Matt Matticks, age 48, comes into your office with his daughter Sondra Matticks, age 25, whose baby, Skee, was born on July 28, 2011. Sondra is unmarried and lived with Matt all year, earning $9,245 during 2011. Matt is unmarried, having divorced Sondra s mother 10 years ago, and made $22,425 as a RTRP. Who qualifies for EITC? Which of the following changes your answer? Sondra earns $29,945 Sondra has 2 other kids, aged 2 and 4 Sondra is 17, not 25 Sondra is 17, and Sondra s mother gets to claim dependency for Sondra as part of the divorce agreement. 1
Eligibility for Earned Income Tax Credit There are 14 official rules for determining who is eligible for the Earned Income Tax Credit (EITC). They fall into 3 categories: A. Rules for Everyone B. Rules to Determine a Qualifying Child C. Rules if There is No Qualifying Child Part A. Rules for Everyone Rule 1. AGI and Earned Income Limitations To qualify for the EITC for the 2011 tax year, a taxpayer s AGI and Earned Income must be less than: $43,998 ($49,078 for MFJ) if there are three or more qualifying children $40,964 ($46,044 for MFJ) if there are two qualifying children $36,052 ($41,132 for MFJ) if there is one qualifying child. $13,660 ($18,740 for MFJ) if there are no qualifying children AGI is Line 38 (1040) or Line 22 (1040A) or line 4 (1040EZ). Earned Income is defined at Rule 7. Rule 2. Taxpayer Must Have a Valid Social Security Number The qualifying children must also have valid social security numbers. If clients have ITIN s instead of social security numbers, they do not qualify for the EITC. If the social security numbers are expected to be official after the filing deadline, either (a) file an extension and wait or (b) file an amended return claim the EITC once the numbers arrive. Rule 3. Taxpayer s Filing Status Cannot Be Married Filing Separately Head of household status may be available to a married taxpayer who did not live with a spouse for the final six months of the year. If the taxpayer qualifies for this and is in a 2
community property state, then the taxpayer s AGI includes that portion of both the taxpayer s and the spouse s wages that are required to be included in gross income. Rule 4. Taxpayer Must Be a U.S. Citizen or Resident Alien All Year An exception is if one spouse of a married filing jointly return is a U.S. citizen or resident alien and they choose to treat the nonresident spouse as a U.S. resident. If this choice is made, the couple is taxed on their worldwide income. Rule 5. Taxpayer Cannot File Form 2555 or Form 2555-EZ These forms qualify taxpayer for the Foreign Earned Income Exclusion. Rule 6. Investment Income Limitation To qualify for the EITC for the 2011 tax year, a taxpayer s investment income must be $3,150 or less. Investment income is interest (both taxable and tax-exempt), dividend, and capital gains. For a married filing jointly return, the combined investment income must be $3,150 or less. Rule 7. Taxpayer Must Have Earned Income Earned Income includes all of the following types of income. Wages, salaries, tips, and other taxable employee pay. Employee pay is earned income only if it is taxable. Nontaxable employee pay, such as certain dependent care benefits and adoption benefits, is not earned income. But there is an exception for nontaxable combat pay, which you can choose to include in earned income. Net earnings from self-employment. Gross income received as a statutory employee. Unlike for AGI, if a married taxpayer qualifies for head of household status and is in a community property state, then the taxpayer s earned income does not include that portion of both the taxpayer s and the spouse s wages that are required to be included in gross income. Registered Domestic Partners also do not include their partner s income for earned income. 3
Part B. Rules to Determine a Qualifying Child Rule 8. Relationship, Age, Residency, and Joint Return Tests To meet the relationship test, the qualifying child must have the following relationship to the taxpayer: daughter, son, stepchild, adopted child, foster child, brother, sister, half brother, half sister, stepbrother, stepsister OR a descendant of any of them. To meet the age test the qualifying child must be younger than taxpayer (or spouse, if filing jointly) AND under 19 at end of year (or a full-time student under 24) OR permanently and totally disabled, regardless of age. To qualify as a student, a student must be enrolled full-time what the school considers full-time) for any parts of five different months. A school can be an elementary school, junior or senior high school, college, university, or technical, trade, or mechanical school. However, on-the-job training courses, correspondence schools, and schools offering courses only through the Internet do not count as schools for the EITC. To meet the residency test the qualifying child must have lived with taxpayer in the U.S. for more than half of the year. A child born in the second half of the year is considered to meet this requirement. To meet the joint return test, the qualifying child cannot have filed a joint return (unless solely for claim of refund). If child is married, the taxpayer can only claim EITC if he/she claims an exemption for the child (or ex-spouse claims exemption under divorce agreement). A claim for refund return means that the return would not need to be filed if it weren t for the fact that taxes had been withheld. Any other case (e.g., income such that tax return must be filed, claiming an education credit) results in the disqualification of the EITC. Example 1. Raina graduates high school on May 27, and starts a full-time job. She turns 19 on November 14. Can her parents claim her for EITC? Solution. While she does not count as under 19, she does qualify as a full-time student since she was in high school for the first five months of the year. Example 2. Lilly, age 21, and Connor, age 25, are married. Lilly s brother, Greg, age 23, lives with them and attends the state university full-time. Can Lilly and Connor claim Greg for the EITC? Solution. Yes. Greg meets the relationship requirement by being Lilly s brother. Since Greg is a full-time student under 24, and younger than Lilly s spouse, he meets the age requirement. He also meets the residency and joint return requirements. (Note: if Greg was older than both Lilly and Connor, he would not meet the age requirement.) 4
Rule 9. Only One Taxpayer Can Claim Any Individual Qualifying Child For a given child, the following six tax benefits are linked: The exemption for the child. The child tax credit Head of household filing status The credit for child and dependent care expenses The exclusion for dependent care benefits The EITC Divorced or separated parents can split these benefits up under certain guidelines, but they are the only exceptions. For parents who were never married, only one parent can take these six benefits for any individual qualifying child. (NOTE: Not all six benefits will necessarily be taken on a given return.) Here is how the IRS will determine the EITC: The child s parent has precedence over anyone else. The parents can choose between them who will take the child. If two parents both file claims for the same child, the one who lived with the child longer has precedence. If that doesn t break the tie, then the one with the higher AGI has precedence. If no parent has a claim, then the qualifying child goes to the person with the highest AGI. If a parent can make a claim, they can allow another to take the claim if the child qualifies and that person has a higher AGI than that of any other parent who can claim the child. (For a joint return, each spouse is considered to have ½ the AGI.) Example 3. Louisa and Frank are not married, but live together with their 2-year-old son, Caleb. Louisa has an AGI of $14,500 and Frank has an AGI of $13,000. Who can take Caleb for the EITC? Solution. Either Louisa or Frank can take the exemption for the child, the child tax credit, head of household filing status, the credit for child and dependent care expenses, the exclusion for dependent care benefits, and the EITC. They cannot split up these tax benefits. If they do not work it out between themselves, the IRS will choose Louisa for these benefits as she has the higher AGI. Example 4. Jon and Martha are divorced. Their 3-year-old daughter, Mia, lives with Martha full-time. Jon provides spousal support and child support. Who can take Mia for the EITC? Solution. Because of the residency test, only Martha can take Mia for the EITC. However, due to the divorce, Jon may qualify for the exemption for the child and the child tax credit. 5
Example 5. Ron and Linda are married, live with their 4-year-old twins, Sam and Scarlett, as well as Ron s mother. Ron and Linda file jointly and have an AGI of $28,000. Ron s mother has an AGI of $22,000. Who can take Sam or Scarlett for the EITC? Solution. Ron and Linda have first claim on the EITC. However, if they choose not to take the EITC, Ron s mother also qualifies to take the twins for the EITC, as her AGI is greater than $14,000 which is half of the joint AGI of the married couple. Rule 10. Taxpayer Cannot Be a Qualifying Child of Someone Else If the taxpayer meets all the requirements of being a qualifying child of someone else, the taxpayer cannot claim the EITC, even if the person the taxpayer qualifies for does not claim the EITC. However, just like the joint return test, if the person the taxpayer qualifies for does not need to and doesn t file a tax return or only files a return for a claim of refund, then the taxpayer may take the EITC. Example 6. Gary is 21 and lives with his mother, Maya, and his son, Adam. Gary is a full-time student and earns $6,200 at a campus job. Maya lives on her Social Security payments. Who can take Adam for the EITC? Solution. Although Gary is a qualifying child of Maya, since Maya does not need to file a tax return, Gary may take Adam for the EITC. Maya cannot take Adam or Gary as she has no earned income. Example 7. Gary is 21 and lives with his mother, Maya, and his son, Adam. Gary is a full-time student and earns $6,200 at a campus job. Maya lives on her Social Security payments, and has a part-time job that pays $2,300 over the year. She files a tax return to claim the money taken from her paychecks. Who can take Adam for the EITC? Solution. If Maya s return solely consists of getting back the taxes taken from her paycheck, Gary may take Adam for the EITC. However, if Maya takes Gary for the EITC, then Gary cannot claim Adam also for the EITC. Maya cannot take Adam for EITC as she makes less than Gary. Part C. Rules if There is No Qualifying Child Rule 11. Taxpayer Must Be at Least Age 25 but Under Age 65 For MFJ, only one spouse needs to meet this requirement. If a spouse dies during the year, their age is the age on the date of death. Example 8. Lilly, age 21 and Connor, age 25 are married. Do they qualify for the EITC? 6
Solution. Yes, since one spouse, Connor, is 25. Rule 12. Taxpayer Cannot Be a Dependent of Someone Else Similar to Rule 10, if the taxpayer meets all the requirements of being a dependent of someone else, they cannot claim the EITC, even if the person they qualify for does not claim them as a dependent. Example 9. Caitlin, age 21, is a full-time student and makes $2,100 at a campus job. Her parents claim her as a dependent. Does she qualify for the EITC? Solution. No, but her parents could take her for the EITC. Rule 13. Taxpayer Cannot Be a Qualifying Child of Someone Else As in Rule 10, if the taxpayer meets all the requirements of being a qualifying child of someone else, they cannot claim the EITC, even if the person they qualify for does not claim the EITC. Rule 14. Taxpayer Must Have Lived in the U.S. More Than Half the Year For this rule and the residency test, the US is considered only the 50 states and the District of Columbia. It does not include Puerto Rico or US Possessions. Common Misconceptions A child must be a dependent to qualify for the EITC. The rules for exemptions are separate from the rules for EITC qualification. There is no calculation of support or income earned by the qualifying child in determining eligibility for the EITC. A single taxpayer must have Head of Household status to qualify for the EITC. The rules for filing status are separate from the rules for EITC qualification. There is no calculation of support in determining eligibility for the EITC. 7
Worked Opening Scenario Example 10: Matt Matticks, age 48, comes into your office with his daughter Sondra Matticks, age 25, whose baby, Skee, was born on July 28, 2011. Sondra is unmarried and lived with Matt all year, earning $9,245 during 2011. Matt is unmarried, having divorced Sondra s mother 10 years ago, and made $22,425 as a RTRP. Who qualifies for EITC? Solution: Skee is a qualifying child for both Matt and Sondra because Skee meets the relationship, age, joint return, and residency requirements. Sondra is not a qualifying child for Matt as she does not meet the age test. Sondra has first claim to the EITC, but she can allow Matt to take the EITC instead since his AGI is greater than hers. Variant 1: Sondra earns $29,945, not $9,245. Solution: In this case, Skee is still a qualifying child for both Matt and Sondra because Skee meets the relationship, age, joint return, and residency requirements. Sondra is not a qualifying child for Matt as she does not meet the age test. Sondra can claim the EITC, but she cannot allow Matt to take the EITC as her AGI is greater than his. Variant 2: Sondra has two other children, aged 2 and 4. Solution: In this case, nothing changes. All three children are qualifying children for both Matt and Sondra because they meet the relationship, age, joint return, and residency requirements. Sondra is not a qualifying child for Matt as she does not meet the age test. Sondra has first claim to the EITC, but she can allow Matt to take the EITC instead since his AGI is greater than hers. Variant 3: Sondra is 17, not 25. Solution: In this case, Skee is still a qualifying child for both Matt and Sondra because Skee meets the relationship, age, joint return, and residency requirements. Sondra is now a qualifying child for Matt as she meets the relationship, age, joint return, and residency requirements. Only Matt can claim the EITC, and he can claim it for both Sondra and Skee. Variant 4: Sondra is 17, and Sondra s mother gets to claim dependency for Sondra as part of the divorce agreement. Solution: In this case, Skee is still a qualifying child for both Matt and Sondra because Skee meets the relationship, age, joint return, and residency requirements. Sondra is now a qualifying child for Matt as she meets the relationship, age, joint return, and residency requirements. Only Matt can claim the EITC, and he can claim it for both Sondra and Skee. So Sondra s mother can take Sondra as a dependent, and Matt can claim the EITC for Sondra. 8
EITC Due Diligence Here is what has motivated the IRS to examine the due diligence of tax preparers in regards to the EITC: EITC Error rate is from 21 to 26%. 70% of EITC returns are prepared by paid preparers Congress enacted due diligence requirements in 1997 Extra steps are required of paid preparers In their public presentations, the IRS has said that they have four tiers of enforcement: Tier 1: Educate Preparers Educational letters alerting both new and experienced preparers with high error probability Tier 2: In-person Visits In-person educational visits by IRS agents and criminal investigators Tier 3: Onsite Audits of EITC records Onsite audits of preparer records, checklists, worksheets, etc. Tier 4: Civil Injunctions or Criminal Prosecutions Civil injunctions can permanently or temporarily bar tax preparation Common Errors The reasons for errors in EITC returns often come from misinterpreting the law, accepting client-given information at face value, and intentional fraud. In general, more than 60% of EITC errors fall into one of the following three categories: Claiming a child who doesn t meet the age, relationship, or residency requirement Incorrect filing status Under or over-reporting income To avoid the first category of error, gather all the facts to determine child eligibility by asking simple and easy to understand questions. Probe the relationships, look for ambiguous answers. You also need to know special rules and exceptions including the AGI and tie-breaking rules. 9
To avoid the second category of error, you need to understand the differences in filing status between single, head of household, and married. These are not the same as the eligibility rules for the EITC. You, not the client, must determine filing status. To avoid the third category of error, you need to look for questionable W-2 forms and unsubstantiated SE income and expenses. You also want to wary of incomes in the sweet spot, where the EITC is maximized. Requirements of Paid Preparers This is spelled in the Internal Revenue Code Section 6695(g) Complete Form 8867, Paid Preparer s Earned Income Credit Checklist Compute the credit using the EIC worksheet or an equivalent Keep records (3 years) Know the law 90% of penalties assessed on paid preparers are for failure to comply with the knowledge requirement. Ask yourself: Would a reasonable and well-informed tax return preparer, knowledgeable in the law, conclude the client-furnished information is questionable? The IRS expects you to recognize incomplete or inconsistent information, not to rely on tax software, and ensure that the EIC worksheet is complete. For returns filed after December 31, 2011, the due diligence penalty for an EITC return is $500. Also, for these returns, preparers must file Form 8867. Individuals and firms who employ others to prepare returns could be subject to due diligence requirements and penalties. Best Practices The IRS has created guidelines as to what they consider to be the best practices for a paid preparer to follow when dealing with a client who potentially may qualify for the EITC. They have divided it into four different areas: 1. Know the Law 2. Get the Facts 3. Ensure Income is Reported Correctly 4. Document the Responses Each of these areas will be looked at more closely. 10
Know the Law The IRS has made resources available for understanding the EITC (see last section of handout), and expects that you will follow the following four procedures: Don t rely on software alone, Explain the law to your clients, Evaluate the information received from your clients, Use resources when questions come up. Ignorance is not a great excuse to give an IRS auditor. Get the Facts The IRS expects you to do a complete vetting of your client, but they have also said that they are not providing sample questions or scripts as they don t want to have a one-sizefits-all protocol. These are the best practice procedures they suggest: Conduct a thorough interview Ask open ended questions Phrase questions in terms your client understands Ask questions of each client, each child, every year Most software now has EITC questionnaires or interview forms. The IRS is most concerned about a) whether the child is qualifying and b) whether there is the correct filing status there is confusion about HOH and considered unmarried and the fact that filing status changes year to year. Ensure Income is Reported Correctly The IRS is looking for accurate reporting of income as underestimating or overestimating income can have great effects on the EITC. Here are areas where they are looking: Reasonableness of known income Propriety of forms Propriety of Schedule C figures Situations that maximize EITC credit Collect all the facts 11
Document the Responses As in a client audit, you are best covered if you have paperwork and documentation for the IRS to examine. Use questionnaires Document additional questions you raised and the client responses Maintain all client records in a secure environment 12
Related Resources Deerwater, Raven EA, PhD. The Do s of Due Diligence. EA Journal 28:3 May-June, 2010: 10-15. IRS Resources Publication 17. Your Federal Income Tax. Earned Income Credit has its own chapter. Can call 1-800-TAXFORM or access online: www.irs.gov/pub/irs-pdf/p17.pdf. Publication 596. Earned Income Credit. Can call 1-800-TAXFORM or access online: www.irs.gov/pub/irs-pdf/p596.pdf. The IRS has a special web address for EITC returns and questions: www.eitc.irs.gov. One of four tabs on this website is Tax Preparer Toolkit : www.eitc.irs.gov/central/main/. Raven Deerwater EA, PhD PO Box 1786 Mendocino, CA 95460 707-937-1099 707-937-1075 (FAX) raven@taxpractitioner.com www.taxpractitioner.com 13