EARNED INCOME CREDIT--STRATEGIES FOR SELF-EMPLOYED TAXPAYERS

By Anthony J. Cataldo II

Historically, the earned income credit (EIC) has been associated with low-income taxpayers. Significant post-Revenue Reconciliation Act of 1993 (RRA93) increases in EIC percentages, and dollar amounts, have created tax planning opportunities for certain classes of taxpayers. The positioning of earned income (EI) and modified adjusted gross income (MAGI) levels may, in some cases, generate after-tax returns as high as 28%.

For simplicity, subsequent examples of EI calculations may not be adjusted for one-half of the self-employment (SE) tax.

Historical Background

The EIC was first established for the 1975 tax year by the Tax Reduction Act of 1975. It was designed partly as a short-term stimulus measure, and partly as a long-term measure for raising low-income taxpayers above the poverty line without disturbing Social Security tax rate
schedules.

The Tax Reform Act of 1976 and the Tax Reduction and Simplification Act of 1977 extended the EIC through the 1977 and 1978 tax years, respectively. The Revenue Act of 1978 made the EIC a permanent component of tax law. The Tax Reform Act of 1986 provided for inflation-indexing of phase-in and phase-out thresholds, where the flat ranges of maximum EIC benefits begin and end. The 1997 tax acts also make adjustments to certain of the computations of the EIC, but did not modify the basic concepts. The calculations presented are all pre-1997 tax act adjustments.

The Functional Nature of the EIC

Exhibit 1 provides a summary of beginning and ending flat ranges and phase-in and phase-out percentages for the 1996 and 1997 tax years. For example, for the 1996 tax year, a taxpayer with one qualifying dependent received 34% for each dollar of EI or MAGI up to the $6,330 threshold. This maximum available EIC of $2,152 (34% of $6,330) is maintained throughout the flat range of $6,330 through $11,610. The EIC is phased-out at a rate of 15.98% for each additional dollar of EI or MAGI in excess of $11,610. At an EI or MAGI level of $25,078, it is completely phased-out or eliminated (i.e., $25,078 ­ $11,610 = $13,468 and $13,468 x 15.98% = $2,152, the maximum EIC).

A tax planning opportunity arises when it becomes possible to legitimately manipulate income or deduction items, shifting or positioning the taxpayer's EI/MAGI forward/backward, toward the EIC-maximizing flat range. The credit rate for single taxpayers is modest. At 7.65%, it represents the employee's portion of Social Security. For taxpayers with one and two or more qualifying dependents, the rates increase significantly to 34% and 40% respectively. These rates remain in effect for the 1997 tax year.

After-Tax, SE Tax, and EIC Profit Percentages

Exhibit 2 provides for calculations of the after-tax, SE tax rates for all five FIT brackets. Adjustments have been made for tax bracket-dependent "above the line" adjustment to income for one-half of the SE tax (i.e., 12.15% for the 28% FIT bracket). The 28% FIT bracket has been used to further illustrate the net EIC profit percentage for self-employed taxpayers with EIC-qualifying dependents.

A self-employed taxpayer in the 28% FIT bracket with one (two) qualifying dependent(s) would not find it profitable to shift EI/MAGI forward toward the flat range, because the 28% FIT bracket exceeds the available EIC profit percentage of 21.85% (27.85%). However, forward EI/MAGI shifting would produce higher refunds or lower tax liabilities for taxpayers through the 15% FIT brackets, reflecting the politically popular work incentive feature of the EIC. And even taxpayers in the 28% or higher FIT bracket and beyond the flat range might find backward positioning profitable.

Planning Strategies

IRC section 179 provides one of the most efficient vehicles for EI/MAGI manipulation and EIC profit-maximization. Tax professionals reluctant to elect the expense election, or selecting the alternative depreciation options for taxpayers with modest profits or net losses from self-employment, may wish to reconsider such decisions.

For example, assume that a taxpayer with one EIC-qualifying dependent has EI/MAGI of $15,000, including self-employment earnings of $1,000, and before depreciation of a $5,000 business asset purchased during the 1997 tax year. As noted in Exhibit 1, this taxpayer is in the phase-out range before depreciation expense.

A preparer might elect to take depreciation of 20% or $1,000 to reduce the taxpayer's self-employment earnings and SE tax to zero. This would also reduce the taxpayer's EI/MAGI to $14,000, and preserve the remaining $4,000 in depreciable basis for SE tax reduction in future tax years. However, the future gross SE tax savings of 15.3% fall below the present net phase-out EIC profit percentage of 18.02% as shown in Exhibit 2. Therefore, the level of combined IRC Section 179 expense election and depreciation should be used to develop a loss from self-employment, pushing the taxpayer backward, into the flat range [i.e., $15,000-$3,070 = $11,930 and $1,000-$3,070 = ($2,070) for the EI/MAGI and self-employment earnings/(losses), respectively].

A reversal of this strategy applies for taxpayers with losses from self-employment. Assume similar facts, except the taxpayer has a loss from self-employment of ($10,000) and the EI/MAGI is now $5,000, after fully electing IRC section 179 expense treatment. In this case, qualifying taxpayers may be able to profit by reducing the amount of the election and pushing their EI/MAGI forward into the flat range of $6,500. Alternatively, the taxpayer might elect the optional method for SE tax calculation. As illustrated in Exhibit 2, the SE tax is more than offset by the EIC phase-in of 34%.

A similar strategy might be employed by taxpayers with low/no EI/MAGI, but in control of closely held corporations, partnerships, or limited liability companies. Flow-throughs of salaries might be implemented to generate a positive EI. This technique can be applied in cases where the net flow-through is minor or negative, and some salary might be legitimately associated with the services provided to the entity by the taxpayer.

The dollar amounts might, of course, be larger. A taxpayer could have salaried earnings of $100,000 and self-employment losses of $90,000 for EI/MAGI levels approximating $10,000. The same planning opportunities and manipulations would apply.

Conclusion

The 1994 tax year was the 20th continuous year of the EIC. RRA93 expanded the EIC to include taxpayers with no qualifying dependents, and significantly increased the credit rates for taxpayers with one or more qualifying dependents. Self-employed taxpayers, particularly those engaged in start-up or growth enterprises face tax planning opportunities that do not exist for other classes of taxpayers. The after-tax returns for the examples above would produce EIC-related "profits" ranging between 6 and 28 percent. *

Anthony J. Cataldo II, is a visiting
assistant professor, Gonzaga University.

OFFSETTING CAPITAL GAINS AND LOSSES UNDER THE TAXPAYER RELIEF ACT OF 1997

By Ed Morris, CPA, Rosenberg, Neuwirth & Kuchner CPAs, PC

The Tax Technical Corrections Act of 1997 (HR 2645, as reported by the House Ways and Means Committee on October 9, 1997) makes numerous corrections to the Taxpayer Relief Act of 1997, including substantive changes to the capital gains rules. Because the
Corrections Act deals with corrections already anticipated in the 1997 forms, it is expected to pass Congress in early 1998. In general, the Corrections Act gives taxpayers the benefit of the doubt by allowing capital loss offsets which are generally very favorable.

Background

The Taxpayer Relief Act of 1997 reduced the top capital gains rate from 28% to 20% (10% for 15% income tax bracket taxpayers), effective for post-May 6, 1997 transactions. Capital assets sold after July 28, 1997 however must generally be for more than 18 months to qualify for the 20% rate. Capital assets held for more than one year but not more than 18 months and sold after July 28, 1997 produce mid-term gains and losses subject to the 28% rate. A transitional rule allows for assets sold after May 6, 1997 and before July 29, 1997 to qualify for the new 20% rate if only held for more than one year. The 1997 act generally retained the 28% maximum rate for gains from collectibles and gains from the sale of certain small business stocks. In addition, a maximum rate of 25% is provided for certain unrecaptured IRC section 1250 gain.

The 1997 act did not directly address how to handle offsetting losses under the new system. Accordingly, there was a lack of certainty over the order in which losses were permitted to offset the different gain classifications.

Technical Corrections to the Rescue

The Tax Technical Corrections Act of 1997 clarifies some of the new capital gain provisions and spells out how capital losses fit in with the new rate reductions. Under the Corrections Act:

* All gains and losses in the "28% basket" will be netted to determine gain subject to the 28% rate. Significantly, net short-term capital loss and any long-term capital loss carryover will be placed in the 28% rate basket. This allows these losses to offset gain taxed at the 28% rate before offsetting gain taxed at more favorable rates.

* If the netting described above results in a loss, this loss would then offset gain taxed at the 25% rate.

* Any remaining loss would then offset gain in the 20% rate basket.

Example

Marty and Geri Lewis have a short-term capital loss of $30,000 in 1997. They have collectibles gain of $5,000 and $5,000 of gain from the sale on September 12 of stock held for 15 months (both of these items are in the 28% group), unrecaptured IRC section 1250 gain of $25,000 in the 25% group, and long-term capital gain of $35,000 in the 20% group. Their net capital gain is $40,000. Under the Tax Technical Corrections Act, Marty and Geri's short-term capital loss completely offsets the $5,000 of collectibles gain and $5,000 of gain on the sale of stock held for 15 months. The $20,000 excess offsets $20,000 of the unrecaptured IRC section 1250 gain of $25,000. They wind up with $5,000 of unrecaptured IRC section 1250 gain (taxed no higher than 25%) and $35,000 of long-term capital gain taxed no higher than 20%.

Holding Periods Also Dealt With

Several code sections allow for an automatic over-12 month holding period in certain situations. The intent was to give taxpayers the best rate, but under the Taxpayer Relief Act of 1997, these provisions would only allow for the 28%, not the 20% rate. The Tax Technical Corrections Act, through conforming amendments, provides that inherited property and certain patents will be deemed to have a holding period of more than 18 months, rather than a year, thus allowing the new lower 20% rates to apply. In addition, the 60% long term gain/loss portion of an IRC section 1256 contract will be treated as gain or loss from property held more than 18 months. Also, the IRC section 1233 short sale holding period rules and the section 1092(f) option holding period rules would be amended to conform these rules with the new 12­18 month holding period.

IRS Releases New Schedule D

The 1997 version of Schedule D has been significantly revised, as might be expected, to cope with the new rates, holding periods, and netting rules. New Part IV Tax Computation Using Maximum Capital Gains Rates consists of 36 lines reflecting the Tax Technical Corrections Act of 1997. A new column (g) has been added to Part II Long-Term Capital Gains and Losses to track gains and losses taxable at the 28% rate.

These new rules are certainly an incentive to use computer programs to prepare 1997 returns. Anyone still doing returns manually will want to think things over before tackling the new formidable 1997 Schedule D. *

Editor:

Edwin B. Morris, CPA
Rosenberg, Neuwirth & Kuchner

Contributing Editor:
Richard M. Barth, CPA