The Earned Income Tax Credit (EITC) and Head of Household Status Tax Benefits or Compliance Burdens

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Sep 2003

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Consumer debtors, because of their financial condition, are entitled to certain tax benefits or advantages. Two of the
most common tax advantages are the earned income tax credit (EITC)<a href="#2" name="2a">2</a> and the ability to claim "head of household"
status on an individual income tax return. Although commonly utilized, these tax benefits are some of the least
understood, most incorrectly asserted and most abused tax benefits claimed. This column discusses their impact on
consumer debtors in bankruptcy.

<h3>Earned Income Tax Credit (EITC)<a href="#3" name="3a">3</a></h3>

The EITC was created in 1975<a href="#4" name="4a">4</a> for individuals and families that meet certain income and eligibility requirements.
The congressional goal of the EITC is to offset the cost of Social Security taxes<a href="#5" name="5a">5</a> and to provide an incentive to
work.<a href="#6" name="6a">6</a> To qualify for EITC, the taxpayer(s) must work and have earned income. Earned income can be wage
income, salaries, tips, union strike benefits and net self-employment earnings. The taxpayer and spouse (if filing
jointly) must have a Social Security number. The taxpayer must be a U.S. citizen or resident alien all tax year. In
claiming the EITC, the filing status of the taxpayer may be single, head of household, qualifying widow(er) or
married filing jointly. The taxpayer cannot use the filing status of married filing separately. Further, the taxpayer
cannot qualify for EITC if the taxpayer has investment income in excess of $2,550.

The taxpayer must also meet three other tests. The taxpayer must be between the ages of 25-65 at the end
of the year, cannot be a dependent of another person and must have lived in the United States for more than half of
the tax year.

A taxpayer may also increase the amount of the EITC if the taxpayer has a "qualifying child." A qualifying
child is defined by three tests: relationship, age and residency. In claiming a qualifying child under the EITC, the
taxpayer must meet all three tests. Under the relationship test, the qualifying child must be a son, daughter, adopted
child, grandchild, foster child or sibling (including step) if the taxpayer cares for the child as his/her own. Under the
age test, the qualifying child must have been at the end of the tax year under age 19, a full-time student under the
age of 24 or any age if permanently and totally disabled. Finally, the qualifying child must have lived with his/her
parent or guardian for more than half the tax year.

EITC recipients must also meet certain income thresholds. Depending on whether the filer is filing single
or married filing jointly, a person can only receive an EITC if s/he has adjusted gross incomes from $11,060 to
$34,178.00. Congress amended the law on EITC in 2002 to significantly alter eligibility. For example, income
calculations are based on adjusted gross income. Earned income no longer includes non-taxable income such as
supplemental military payments for housing or combat pay. Married filing jointly status is afforded an adjusted
gross income limit that is $1,000 more than other statuses.

Qualifying for EITC status is critically important to low-income families. IRS research suggests that an
EITC can increase a family's gross annual income by as much as a third, and if the taxpayer also receives a
state-based EITC, gross income may increase by as much as 57 percent.

The IRS actively encourages taxpayers to seek the EITC benefit through media publication, publication to
tax preparers or when the taxpayer utilizes IRS taxpayer services. As such, the IRS is actively engaged in
encouraging qualified taxpayers to use EITC. Conversely, the IRS is also actively engaged in ensuring that EITC
claimants are not doing so fraudulently or by mistake.

IRS research indicates that tax returns with EITC claims are plagued by a high rate of non-compliance. The
problem became so acute that Congress allocated under the Balanced Budget Act of 1997 an allocations cap of $716
million to be used for fiscal years 1998-2002 for EITC compliance initiatives that include expanded customer
service, public outreach programs, strengthened enforcement activities and research efforts to reduce EITC erroneous
filings. The majority of the appropriations were used for post-filing activities (examination of tax returns and
education on how to properly claim EITC). Although quantifying the success of the program is difficult, the IRS
estimates suggest that the IRS has projected and/or collected roughly $5 billion in revenue from math error
adjustments and exam.

The most common errors regarding EITC include a qualifying child that does not meet the eligibility
requirements, under-reporting income using invalid Social Security numbers, making math errors and failing to
meet the age requirements for EITC. Taxpayers had the most difficulty in proving that a qualifying child met the
residency requirement‹six months to a full year of residency with the taxpayer.

<h3>Head of Household Status</h3>

To qualify for head of household status, the taxpayer may be unmarried with a dependent child and must
have provided more than half the cost of maintaining the household for the dependent. Alternatively, a person may
also qualify for head of household status if married, but must have filed a separate return, and show that the
claimant's spouse did not live with the taxpayer for the last six months of the tax year, and that the taxpayer
provided support for the dependent that exceeded half the cost of the total support for the dependent for the entire
tax year.

Case law has consistently held that to claim head of household status, the parent must prove that the parent
(taxpayer) provided over half of the support for the child(ren). 26 U.S.C. (§§2 and 152); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… v. CIR, 554
F.2d 564, 569 (2nd Cir. 1977)</a> (to prove dependency status under §152, "the taxpayer must first establish the total
costs expended on behalf of the claimed dependent from all sources and then demonstrate that over half of this
amount was provided by the taxpayer"); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4… v. United States, 428 F.2d 274, 282 (6th Cir. 1970), cert. denied,
401 U.S. 910 (1971)</a> (burden on the issue of claiming head of household on taxpayer); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3… v. CIR, 356 F.2d
898, 900 (7th Cir. 1966)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4… v. CIR, 46 T.C. 515, 517 (1966)</a> (where evidence is convincing that the taxpayer
furnished more than one-half of the support, a dependency exemption will be allowed).

<h3>Assertion in Bankruptcy of EITC and Head of Household</h3>

The intersection of the EITC and head of household status comes into play generally as a confirmation
issue or objection to IRS proofs of claim in chapter 13 cases. In chapter 7 cases, EITCs are contested as to whether a
refund based on an EITC is property of the estate.

For example, in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Cobb, 216 B.R. 676 (Bankr. M.D. Fla. 1998)</a>, the debtors were required to file tax
returns in accordance with local rules that required them to file all state and federal tax returns as a condition of
confirmation. The debtors responded to the court's order requiring them to file their delinquent returns by arguing
that the IRS had not proven the debtors were required to file the returns. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; Although entitlement to EITC or head
of household was not the issue in Cobb, preparation of the tax returns was. In the context of a plan confirmation
hearing, submission of tax returns that assert EITC or head of household status as a condition of confirmation<a href="#7" name="7a">7</a> will
subject the returns to higher scrutiny now that the IRS has made a focal point of tax compliance proper
documentation of EITC and head of household status.

As such, consumer lawyers can expect that if their clients assert these tax benefits, debtors can expect that
their returns will be closely reviewed for accuracy and compliance. Therefore, should the IRS not accept the debtors'
tax returns, debtors' counsel will have to ensure that the debtors have sufficient documentation to support the tax
benefit. Otherwise, confirmation can be held up awaiting a determination of whether the EITC or head of household
status was properly claimed.

Additionally, should the debtor object to the IRS's proof of claim on the basis that the IRS did not
properly disallow the EITC or head of household status, litigation ultimately will involve sufficiency of proof
through documentary evidence. Proof of EITC and head of household status is complicated by the challenge of the
debtor coming forward with supporting documents. Many times, the debtors may have prepared the returns
themselves without an eye toward proof or retained tax preparers not properly trained in making these types of
determinations. Further, the debtor's ability to retain documents can be complicated by a debtor's change in
residence predicated on a loss or change in jobs or changes in marital status. Consequently, debtors and their
counsel must be prepared to substantiate the validity of tax returns or fall subject to additional assessments for
unreported income, penalties and interest.

Moreover, in a chapter 7 context, debtors may have to compete with trustees for refunds based on EITCs.
Some debtors may believe that if a petition is filed prior to the end of the tax year (which determines application of
the tax attribute for accrual), the debtor, and not the estate, is entitled to the entire refund for the tax year that is
based on the EITC. Generally, if the EITC exceeds the individual's tax liability, the excess is treated as an
overpayment under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… U.S.C. §6402</a> and refunded to the taxpayer as if the taxpayer had overpaid his/her tax. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
U.S.C. §6402</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Montgomery, 224 F.3d 1193, 1194 (10th Cir. 2000)</a>. Nonetheless, a majority of courts, most
notably the Sixth Circuit, have found that EITCs are property of the estate under §541(a). <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Johnston, 209 F.3d
611 (6th Cir. 2000)</a> (other citations omitted). As such, the refund is prorated through the date of the petition, with
the portion that is pre-petition becoming property of the estate. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; Further, EITCs are subject to offset for the
payment of government obligations, including student loans. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5… v. United States Dept. of Education, 5 F.3d
1414 (11th Cir. 1993), cert. denied, 512 U.S. 1226 (1994)</a>.

<h3>Conclusion</h3>

Filing head of household on an individual income tax return or claiming an EITC can significantly increase
an individual's adjusted gross income. That said, asserting these tax benefits while in bankruptcy will most likely
subject the debtor/taxpayer to heightened review of the claimed benefit.<a href="#8" name="8a">8</a> Moreover, EITCs or a claim of head of
household status that are fraudulently based could, at a minimum, result in further assessments and penalties.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The views expressed in this article are Mr. Gargotta's and do not necessarily reflect the views of the
Department of Justice or Internal Revenue Service. <a href="#1a">Return to article</a>

<a name="2">2</a> The EITC is defined in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… U.S.C. §32 (RIA Ed. 2001)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> All of the information regarding EITC can be found at the IRS's web site, www.irs.gov, and typing in the
search term "earned income tax credit." <a href="#3a">Return to article</a>

<a name="4">4</a> The program was expanded in 1993 to increase annual aggregate benefits as a feature of the Clinton
Administration's plan for welfare reform. Nonetheless, there continues to be a significant debate as to whether
EITCs accomplish two primary goals: increasing efforts to work among the poor and simplifying the administration
of the welfare bureaucracy. For an excellent discussion on these issues, see Alstott, "The Earned Income Tax Credit
and the Limitations of Tax-based Welfare Reform," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1… Harv. L. Rev. 533 (1995)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> Payroll or "FICA" taxes are defined under <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… U.S.C. §§3402-3405</a>; 6051 (RIA Ed. 2001). <a href="#5a">Return to article</a>

<a name="6">6</a> The theory behind increasing a person's desire to work is that the more that a person works (earns income)
the greater the EITC is, up to certain amount. <a href="#6a">Return to article</a>

<a name="7">7</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Vomhof, 207 B.R. 191 (D. Minn. 1997)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Nygaard, 213 B.R. 877 (Bankr. M.D. Fla. 1997)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> For a discussion of how the review or examination process works and why it is difficult to determine if the
EITC was fraudulently or mistakenly claimed, see Book, "The IRS's EITC Compliance Regime: Taxpayers Caught in the Net," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8… Or. L. Rev. 351 (2002)</a>. <a href="#8a">Return to article</a>

Journal Authors

Craig A. Gargotta

Journal Date

Monday, September 1, 2003 - 12:00

Bankruptcy Rule

2003