The Flawed Earned Income Credit

A single mom, whom we’ll call “Mary”, works hard without support from her ex to provide for her child, and makes about $35,000 per year.  Unfortunately, she makes too much money to qualify for the so called “Earned Income Tax Credit.”  During 2011, she lost her job due to company downsizing.  But, since she lost her job in October, her earnings for 2011 were still close to $30,000 – still too high to qualify for the EITC (with one child).  If she had lost her job in July or maybe August, her earnings would have been low enough to qualify.

Unfortunately, qualifying for the EITC has a lot to do with timing.

Mary is still unemployed and looking for a job.  It could be March or April before she lands a good job.  In other words, she could start working “just in time” to NOT qualify for the EITC again in 2012.  Even though she will have been out of work for 6 months, since those 6 months are split between 2011 and 2012, she doesn’t get the EITC for either year.  This is what you call a “wacky” system that only someone in D.C. could have come up with.

A single parent, claiming 3 dependents, can hit the “sweet spot” of EITC by earning between $12,750 and $16,650 during the year.  They can get EITC of up to $5,751 added on to their Income Tax Refund.  For 2 dependents the EITC is $5,112.

Another single mom that I know has supported 2 children on only about $17,000 per year for the past few years.  Unfortunately, last year she got a second job at a gas station and made an extra $5,000.  This extra income significantly decreased her EITC this year.  Only someone in D.C. could devise such a system that punishes a single mom for getting a second job.

The third situation is about two divorced parents living together with each having children of their own.  They each are providing for their own “household” and paying for each of their children’s expenses.  Thus, they both claim Head of Household and the EITC.  They each get $3,000 – $5,000 per year from EITC.  Then they get married.  Suddenly they no longer qualify for the EITC at all because together they make “too much money” to qualify for EITC.  Again, only a bureaucrat in D.C. could devise a system that encourages co-habitation and punishes married people.

All three of these situations are actual situations and I know all of these people personally.  The EITC is one of the many flaws in our current tax system that needs to be fixed.

Here is how it could be fixed:

1. If you’re going to have EITC at all, allow people to apply for EITC any time during the year using the past 12 months of income.  This could be done on an amended Form 1040X.  They would need to wait 12 months before applying again.

2. In order to not “punish” someone for getting a second job, allow people to take an average income over the past 3 years to determine their EITC.  Putting this in place would help those people who didn’t realize that they were going to be “punished” for working a second job and would allow them to decide going forward, after meeting with their tax professional, if they want to keep working the second job.  When you consider child care, social security and medicare taxes and the decrease in EITC it is hardly worth it for someone to work a second job.

3.  Allow married couples to file as “Single” if they so choose with only one being allowed to file as “Head of Household”.  And, no longer allow people living together to each file as “Head of Household”.  There should only be one “Head of Household” filing per physical address.

1 Down, 5 To Go

January 31st is finally gone!  The following items were due on January 31st:

W-2′s

1099′s

941′s, plus payments for those less than $2,500 in payroll taxes for the quarter.  You have until Feb. 10th to actually file the 941 if you made your deposits on time.  The payment, however, is due by Jan. 31st.

940′s, plus payments.  You have until Feb. 10th for this as well, if you made the payments on time.  If you owe more than $500, chances are you should have made a deposit during the year.  The payment is due by Jan. 31st.

State Unemployment Taxes

There are six primary days a year that cause stress for tax and accounting professionals.

They are:

January 31st

February 28th

March 15th

April 15th

September 15th

October 15th

There are others as well.  But, those are my six.

Now we can move on to bigger and better things.  Like preparing tax returns!

Romney Releases 2010 Tax Return

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Mitt Romney released his massive 203 page 2010 tax return yesterday.  The big story is the 14% tax rate that he pays.  But, to me, as a tax professional, my eyes went to Schedule A, Line 22, Tax Preparation Fees.  I’m always curious what high profile individuals pay for tax preparation services.  And, guess what?  The line is blank.  Is this a mistake?  Did Pricewaterhousecoopers LLP do it for free?  He was way over the 2% threshold so the tax preparation fees would have been a dollar for dollar deduction.  Oh, well,  I guess I’ll focus on the 14% issue.

Here are the facts:

1) His income was about $21.6 million

2) The majority of his income was from Capital Gains ($12.5 million)

3) The next largest portion was from Dividends ($4.9 million)

4) The third largest portion was from Interest ($3.3 million)

Capital gains are taxed at 15%.  There is a reason for that.  It encourages investment.  Raise the capital gain rates and you discourage investment.

Dividends are also taxed at 15%.  The reason for this is because they have already been taxed at the Corporate Income Tax rate of 35%.  Corporations don’t get a deduction for dividends.

Interest is taxed as ordinary income which means Mitt Romney paid 35% on his Interest Income.  This is because Corporations DO get a deduction for interest payments and therefore don’t have to pay taxes on it.

5) He gave $3 million to charity.  This helped reduce his taxable income and, of course, his overall tax rate.

6) He earned $593K from speaking fees, director fees, etc.  He reported this on Schedule C and paid the FULL Medicare Tax on it.  He could have run it through an S-Corporation, paid himself a reasonable salary, and then taken the rest of it as a distribution, like Newt Gingrich did, but he didn’t .   Not that there is anything wrong with the way Newt did it.  I’m just pointing out the facts.  Romney should at least get some points for that.

There is a lot to this tax return and I’m not going to spend the time going through all the forms.  I’ll just stick with the basics.  But, I don’t see anything big here.  The only ammunition will be for those who want to play class warfare.

Can You File Your Tax Return Using Your Last Pay Stub?

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One question tax preparers frequently get asked is “Can I file my return using my last pay stub?”

There are really two questions here:  1) Can an individual file their own return using a pay stub instead of a w-2?  And, 2) Can a paid tax preparer prepare and file a return based on a pay stub instead of a W-2?

First, let me deal with the issue of paid preparers.  The IRS states that it is “against e-file rules” for preparers to file with a pay stub instead of a W-2.  This is on their web-site here.  When they say “against e-file rules” I’m not sure exactly what rules they are talking about or if they are specifically referring to paid preparers or individuals filing their own return.  I’ve read through the entire Handbook for Authorized e-file Providers and the only mention of preparing returns from a pay stub is on page 48 where it talks about advertising.   But, on page 30 it states that paid preparers must retain “Copies of Form W-2, W-2G and 1099-R”.  How can you retain a copy of it if you never saw the W-2 in the first place?  Do you really think that the client is going to bring back the W-2 later just so that you can keep a copy?  I don’t think so.  Paid preparers need the W-2 up front in order to protect themselves.  In addition, one of the questions that must be answered in all professional tax software when e-filing is “Check if this is hand written, altered or appears not to be a true W-2″.  So, how would you know if you haven’t seen it?

Now, the issue of an individual filing their own return.  I cannot find any specific rules against this.  However, here are a couple of things to keep in mind:

1. Not all information is on the pay stub.  The Employer EIN, for example, isn’t.  Got it on last year’s W-2?  Not so fast.  Sometimes employers change their EIN.  Also, the categorization of retirement contributions isn’t clear on the last paystub.  For example on the W-2 in Box 12A, 12B, 12C or 12D it usually has the letters A,B,C,D, etc. denoting what kind of retirement contribution it is.  There are other items as well that might appear on the W-2 that are not on the last pay stub.

2. Your YTD info on your pay stub might be wrong.  This could be for a variety reasons, like your employer changing software or payroll services during the year.  Sure, they should have reconciled everything and made it accurate but they may not have done that yet when you got the last pay stub.  Some payroll preparers double check all the numbers before sending out W-2′s and if they find an error and then correct it on the W-2 it would be different from the last pay stub.

In summary, paid preparers definitely need to see the actual W-2 and taxpayers filing their own return would be best served to wait for it as well.

Decrease Your Chances of Being Audited

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According to IRS statistics your chances of being audited as a Schedule C Sole-Proprietorship are 3-4%, compared to an S-Corporation of 0.3-0.4%.  So, your chances of being audited are about 10 times greater as a sole-proprietor.  That sounds like a great reason to set your business up as an S-Corp!

Other ways to reduce your chances of being audited are: