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)² 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.

Earned Income Tax Credit (EITC)³

The EITC was created in 1975⁴ 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 taxes⁵ and to provide an incentive to work.⁶ 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.

Head of Household Status

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); Turecamo v. CIR, 554 F.2d 564, 569 (2nd Cir. 1977) (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"); Hogg v. United States, 428 F.2d 274, 282 (6th Cir. 1970), cert. denied, 401 U.S. 910 (1971) (burden on the issue of claiming head of household on taxpayer); Rezazadeh v. CIR, 356 F.2d 898, 900 (7th Cir. 1966); Stafford v. CIR, 46 T.C. 515, 517 (1966) (where evidence is convincing that the taxpayer furnished more than one-half of the support, a dependency exemption will be allowed).

Assertion in Bankruptcy of EITC and Head of Household

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 In re Cobb, 216 B.R. 676 (Bankr. M.D. Fla. 1998), 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. Id. 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 confirmation⁷ 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 26 U.S.C. §6402 and refunded to the taxpayer as if the taxpayer had overpaid his/her tax. See 26 U.S.C. §6402; In re Montgomery, 224 F.3d 1193, 1194 (10th Cir. 2000). Nonetheless, a majority of courts, most notably the Sixth Circuit, have found that EITCs are property of the estate under §541(a). In re Johnston, 209 F.3d 611 (6th Cir. 2000) (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. Id. Further, EITCs are subject to offset for the payment of government obligations, including student loans. Bosarge v. United States Dept. of Education, 5 F.3d 1414 (11th Cir. 1993), cert. denied, 512 U.S. 1226 (1994).

Conclusion

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.⁸ Moreover, EITCs or a claim of head of household status that are fraudulently based could, at a minimum, result in further assessments and penalties.

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Footnotes

¹ 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. Return to article

² The EITC is defined in 26 U.S.C. §32 (RIA Ed. 2001). Return to article

³ 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." Return to article

⁴ 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," 108 Harv. L. Rev. 533 (1995). Return to article

⁵ Payroll or "FICA" taxes are defined under 26 U.S.C. §§3402-3405; 6051 (RIA Ed. 2001). Return to article

⁶ 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. Return to article

⁷ See, e.g., In re Vomhof, 207 B.R. 191 (D. Minn. 1997); In re Nygaard, 213 B.R. 877 (Bankr. M.D. Fla. 1997). Return to article

⁸ 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," 81 Or. L. Rev. 351 (2002). Return to article