The Child Tax Credit: Benefits, Limitations, and Complexities

By James M. Hopkins

In Brief

Calculations Only a Computer Could Love

Congress and the IRS have the best intentions in crafting and revising IRC sections that deal with credits and deductions for children and other dependents. However, keeping up with the changes and using the various provisions appropriately has become increasingly complex. This problem is especially acute when a taxpayer's life circumstances change over time and involve a combination of IRC provisions that are related but often don't consider those relationships.

IRC sections 21, 22, 23, and 24 provide the fundamental provisions for credits and deductions for children and other dependents, and the IRS has given guidance and direction for stacking credits and deductions in combinations of circumstances. The benefits are clear and definite, but taxpayers and advisors need to understand the breadth and recent history of the regulations.

Prior to 1998, the IRC had no provision for credits based solely on the number of family dependents. Instead, a dependent care tax credit was available under IRC section 21 to taxpayers that incurred certain dependent care expenses. In addition, taxpayers were allowed a dependency exemption ($2,650 in 1997) for each dependent.

To offset a rising tax burden, the $2,650 personal exemption is adjusted annually for inflation. Despite these adjustments, however, the Taxpayer Relief Act of 1997 (TRA 97) Committee Report states that the value of the personal exemption has declined by one-third over the past 50 years. Therefore, to reduce the tax burden on families with dependent children, Congress created the child tax credit (CTC).

Amount of Credit

Beginning with 1998, taxpayers are eligible to claim a credit ($400 in 1998) for each dependent qualifying child (QC) under age 17, assuming the QC's tax identification number is provided. In 1999, the CTC increased to $500 for each qualifying child under age 17.

Example 1. Ignoring credit reductions for higher-income individuals, a taxpayer with two QCs would be able to claim an $800 ($400 x 2) credit in 1998 and a $1,000 ($500 x 2) credit in 1999 and beyond.

Congress calculated the benefit of this credit to be nearly $2.7 billion in 1998 and as great as $18.1 billion in 1999. But despite the apparent benefits, the CTC also has limitations:

* The 1999 credit amount of $500 is not indexed for inflation.
* The CTC is not allowed for a tax year covering less than 12 months unless by reason of the taxpayer's death.
* The CTC begins to phase out at a certain income level for each filing status, similar to personal or exemption phaseouts.

Credit Phaseout

The CTC phases out when a taxpayer's modified adjusted gross income (MAGI) exceeds certain thresholds. The credit is reduced by $50 (but not below zero) for each $1,000 (or fraction thereof) by which a taxpayer's MAGI exceeds the threshold. MAGI is computed by adding back to a taxpayer's AGI the following types of income:

* Income of U.S. citizens or residents living abroad.
* Income for residents of Guam, American Samoa, the Northern Mariana Islands, and Puerto Rico.

The phaseouts start when MAGI exceeds $110,000 for married couples filing jointly (MFJ), $75,000 for single individuals or heads of household (SINGLE/HH), and $55,000 for married couples filing separately (MFS). The IRS has separate phaseout tables for each year beginning in 1998 because the credit amount for each QC changes each year. However, the $50 reduction for each $1,000 of excess MAGI is the same for all years. The CTC phaseout ranges for 1998 and 1999 are shown in the Exhibit.

Example 2. A married couple filing jointly has $116,000 of MAGI in 1999. They have one QC under age 17. Their MAGI of $116,000 exceeds their threshold limit by $6,000. This $6,000--divided by $1,000, resulting in 6, multiplied by $50--results in a $300 CTC reduction and therefore only $200 ($500 ­ $300) of available CTC. If MAGI were $116,001, the credit would be reduced by another $50 because 6.001 would be rounded to 7, resulting in $350 ($50 x 7) of lost credit.

In this MFJ example, the phaseout range increases from $110,000­119,001 to $110,000­149,001 as the number of qualifying children increases from one to four for 1999.

Example 3. An MFJ couple has $125,000 of MAGI in 1999. They have one QC under age 17. In this case, the couple cannot claim any CTC because the phaseout for one QC ends at $119,001. However, if the couple has four qualifying children under the age of 17, they are eligible for the credit, with a total CTC of $2,000 ($500 x 4) in 1999 before phaseouts. Their MAGI ($125,000) is $15,000 over the $110,000 threshold, resulting in a credit reduction of $750 (15 x $50). Therefore, the actual credit available to the couple would be $1,250 ($2,000 ­ $750) before possible additional limitations.

Who Is a 'Qualifying Child'?

Only taxpayers with a QC are eligible to claim the CTC. In addition to being a U.S. citizen, resident, or national, three other requirements must be satisfied in order to be classified as a QC:

* Per IRC section 24(c), the taxpayer must be entitled to a dependency deduction under IRC section 151. (However, the CTC does not affect the amount of a taxpayer's dependency exemption.)
* The individual must bear a relationship to the taxpayer as described in IRC section 32(c)(3)(B). Specifically, the individual must be a son, daughter, stepson, stepdaughter, or eligible foster child.
* The individual in question must be under age 17 by the close of the calendar year in which the tax year of the taxpayer begins.

If these requirements are met, an individual is classified as a QC and the CTC may be applied against a taxpayer's regular tax liability. For example, a taxpayer has a 13-year-old son who lives at home, a 14-year-old foster child considered to be a dependent, and a daughter who turned 17 on December 20 of the tax year. In this case, the 13-year-old son and the foster child are considered qualifying children. However, because the daughter turned 17 before the end of the year, she is not considered a QC, even though she is claimed as a dependent.

Although IRC section 24 is silent regarding who gets the CTC when the parents are divorced, generally the parent entitled to the dependency exemption would be entitled to the CTC, because it is one of the requirements for the CTC.

Determining who gets the CTC when the parents are divorced is different than determining the child and dependent care credit when the parents are divorced. A divorced or legally separated taxpayer that has custody of a disabled or under-age-13 child is entitled to the child and dependent care credit. This eligibility holds true even if the parent released the right to the dependency exemption for the child or is not entitled to the exemption under the terms of a pre-1985 divorce decree.

Stacking Order of Nonrefundable Personal Credits

No official source explains how to apply the stacking order for nonrefundable personal credits (NPC). The order was less important when all NPCs had to be used in the year earned or be lost. The IRS applied the stacking order on an individual's tax return based on an ascending order of the IRC section authorizing the specific NPC.

With recent adoption of NPCs that can be carried forward, such as the adoption credit, mortgage interest credit, and first-time homebuyer's credit for District of Columbia residents, the stacking order must be considered to determine how the credits are used to offset income tax liability.

IRC sections 23(c) and 25(e)(1)(C), as amended by the IRS Restructuring and Reform Act of 1998, address the stacking order for certain credits. However, IRC section 24, which authorizes the CTC, makes no mention of the order in which the CTC is to be used. A logical decision is to apply the CTC in ascending IRC section number order, as described above, which would place it after the IRC section 22 credit for the elderly and disabled. (The IRC section 23 adoption credit would be placed later in the stacking order, as specified on Form 1040.)

Based on the 1998 and 1999 IRS forms (Form 1040, Form 8812, and Pub. 972) for this calculation, as well as discussions with IRS personnel and examples in explanatory material, the IRS applies the nonrefundable CTC in the ordinary stacking order of NPCs, as shown below. This becomes especially important if portions of the CTC are refundable because of the number of QCs. For example, if a taxpayer has $1,000 of regular tax (and no minimum tax) and more than $1,000 of dependent care credit and CTC, the dependent care credit will apply first, allowing some or all of the CTC to become refundable if the refundable CTC is otherwise available.

Using the Child Tax Credit to Offset Tax

The nonrefundable CTC combines with other personal, nonrefundable tax credits and offsets the excess of the regular tax liability over the taxpayer's tentative minimum tax (before the alternative minimum tax foreign tax credit) for any tax year. Generally, the following nonrefundable personal credits (the Part IV, subpart A credits) are used in the following order when offsetting this excess tax:

* Child and dependent care credit (IRC section 21)
* Credit for the elderly and permanently and totally disabled (IRC section 22)
* Post-1997 nonrefundable child tax credit (IRC section 24)
* Post-1997 Hope Scholarship and lifetime learning credit (IRC section 25A)
* Certain interest on home mortgages (IRC section 25)
* Adoption credit (IRC section 23)
* First-time homebuyer's credit for District of Columbia residents (IRC section 1400C).

The 1999 Form 1040 follows this stacking order, although it shows the IRC section 25 credit as Form 8396 credit below the line for adoption credit. The 1999 Form 1040 does not have a separate line for IRC section 1400C credits, but allows the credit to be inserted on Line 47(d).

The IRS Restructuring and Reform Act of 1998 modified certain IRC sections clarifying how such credits should apply. Other credits, including the foreign tax credit (IRC section 27) and general business credits (IRC section 38), are applied after nonrefundable personal credits.

In general, the CTC is considered a nonrefundable personal credit. The CTC may also be a refundable credit as well as a supplemental credit in the following cases:

* If a taxpayer has three or more QCs, some of the CTC may be refundable (called an additional credit on Form 8812 and in TRA 97).
* Generally, where a taxpayer has one or two QCs, part of the CTC may be treated as a supplemental CTC and added to the earned income credit but provides no additional benefit, as discussed in the next section.

Supplemental Child Tax Credit

The supplemental child tax credit calculation, as modified for technical corrections, is the method by which the nonrefundable CTC is converted to a refundable credit for low-income taxpayers.

The supplemental child tax credit is defined as the lesser of--

* the amount by which the taxpayer's nonrefundable credits allowed under subpart A of Part IV (which was limited to an amount not to exceed the amount by which the taxpayer's regular tax exceeds tentative AMT and without regard to any supplemental CTC) are increased by the CTC or
* the excess of--
* the taxpayer's total credits including the earned income credit (EIC) (but excluding taxes withheld on wages, at the source on nonresident aliens, and credits for certain uses of gasoline and special fuels) and before the supplemental credit, over
* the sum of the taxpayer's regular tax and Social Security taxes.

The mechanics of applying the supplemental CTC, which are complicated, end in no real additional benefit to the taxpayer. In effect, the calculation results in the CTC being usable to the extent of the taxpayer's regular tax liability (See "The Disappearing Supplemental Child Credit," The Tax Adviser, May 1999). As a result, the IRS did not require a supplemental CTC calculation on 1998 returns, and the 1999 Form 1040 has no line for such calculation.

The following examples show the workings of the supplemental CTC and why it produces no additional benefit to the taxpayer:

Example 4. For 1999, a single taxpayer has two QCs ($1,000 of CTC), $18,000 AGI from salary, $1,377 FICA taxes, a $510 regular tax liability on a $3,400 taxable income, no tentative minimum tax, and $2,649 of EIC.

The taxpayer's nonrefundable child tax credits are increased by the CTC in the amount of $510, not by the full $1,000 of the CTC. The first part of the test is limited to $510, that is, it cannot exceed the regular tax liability in excess of the tentative minimum tax, zero. The second part of the test adds certain credits, including EIC, and subtracts the sum of taxpayer's regular income tax and FICA taxes. This calculation results in $510 of CTC and $2,649 of EIC, or $3,159. Take away $510 of regular tax and $1,377 of FICA, or $1,887, and the difference is $1,272.

The supplemental credit amount is the lesser of the two tests ($510 and $1,272), so the supplemental CTC is $510. Reclassifying a portion of the CTC into a supplemental CTC does not increase it higher than the taxpayer's regular tax liability.

The taxpayer does not benefit, because reducing a nonrefundable tax credit and increasing a refundable credit by the same amount has a "wash" effect. The $490 balance of the CTC ($1,000 less the $510 portion) is lost.

Example 5. Assume the facts in Example 4, adding $260 of dependent child credit (DCC). Because the DCC is applied before the CTC in the stacking order of nonrefundable tax credits, the taxpayer's $510 of regular tax liability will first be reduced by $260 of DCC, leaving a regular tax liability of $250.

The first part of the supplemental CTC test would result in $250, the increase in nonrefundable credit as a result of CTC. (The increase is $510 less the DCC, or $510 ­ $260.) The second test is not considered, because it would result in a larger number. The remaining $750 ($1,000 ­ $250) of CTC is lost.

Alternative (Refundable) Child Tax Credit

The alternative, sometimes called additional CTC, applies to families with three or more children. The additional credit converts what would be unusable credits against regular taxable income to a refundable credit to the extent that Social Security taxes paid exceed the earned income credit. Social Security taxes for purposes of the alternative or additional CTC mean one-half of the self-employment tax, certain railroad retirement taxes, and the employee's share of FICA and Medicare taxes.

Example 6. For 1999, a single taxpayer has three QCs, $18,000 AGI from salary, $1,377 FICA, a $98 regular tax liability on a $650 taxable income, no tentative minimum tax, and $2,649 of EIC.

The taxpayer has $98 nonrefundable CTC and no refundable CTC, calculated as shown below. The CTC would be $1,500 ($500 x 3). However, none of the CTC in excess of the regular tax liability of $98 is available because FICA tax ($1,377) must exceed EIC ($2,649). The balance of the CTC of $1,402 ($1,500 ­ $98) is lost.

If the taxpayer had other nonrefundable personal credits that had no carryover provision, such as education credits, those would also be lost, because the CTC would offset the regular tax liability to zero. The taxpayer has no refundable CTC unless FICA taxes, as modified above, exceed EIC, which is not the case.

Example 7. For 1999, two married taxpayers have two QCs, $32,250 AGI, $2,467 FICA, no EIC, DCC of $400, Hope credits of $1,900, and CTCs of $1,000. Total nonrefundable credits are $3,300. Their regular income tax liability is $2,108 on a $14,050 taxable income, and they have no tentative minimum tax.

The taxpayers can use $400 of DCC and $1,708 of Hope credits to offset their regular income tax liability. The education credit applies before the CTC to reduce the regular income tax liability, leaving the CTC of $1,000 for treatment as a refundable credit. No refundable credit is available because the couple has only two QCs. As a result, the CTC and $192 ($1,900 ­ $1,708) of Hope credits are lost.

Example 8. Assume the same facts as Example 7, except with three QCs. Regular income tax liability is now $1,695 on a taxable income of $11,300. Child tax credits are $1,500 and total nonrefundable credits are $3,800. The taxpayers' nonrefundable credits of $1,695 ($400 of DCC and $1,295 of Hope) reduce the regular income liability to zero. The balance of the Hope credit of $605 ($1,900 ­ $1,295 ) is lost. Because the couple has three or more QCs, a refundable calculation is in order. Because the FICA tax plus regular income tax net of applicable credits ($2,678 + 0) is in excess of EIC (in this case, zero) by $2,467, the taxpayers can take their $1,500 of CTC as a refundable credit.

Stacking the Credits

Complexities arise when taxpayers have other personal nonrefundable credits, such as DCCs, education credits, and personal credits with carryover provisions (adoption credit, home mortgage interest, and the first-time homebuyer's credit for District of Columbia residents).

Personal credits that may be carried to a subsequent year are applied after personal credits that do not have a carryover provision, to reduce regular income tax liability. All nonrefundable credits reduce regular income tax before any refundable EIC or refundable CTC are applied.

Alternative Minimum Tax and Child Tax Credit

In the prior examples, the tentative minimum tax was zero, leaving the regular income tax as the maximum amount of nonrefundable credits that could be used. IRC section 26(a) limits the amount of nonrefundable personal credits, including the CTC, that can be used to the excess of the regular income tax liability over the tentative minimum tax. Nonrefundable credits in excess of that amount without a carryover provision are lost.

For tax year 1998 only, Congress removed the IRC section 26(a) limitation by treating the tentative minimum tax as zero. This change allowed taxpayers to fully use all nonrefundable credits against their regular income tax liability. This benefit is unavailable for 1999 and later years unless Congress passes extender legislation. (See Sidebar for update)

Good Intentions, But ...

When Congress enacted the CTC, its intention was to offset the decline in the value of the dependency exemption and the negative effects of high FICA taxes on low-income taxpayers with qualifying children. Unfortunately, Congress created a monstrosity of complexity for professional tax preparers and advisors and made the IRC incomprehensible to its beneficiaries. If Congress were to review the child tax credit, a reasonable revision would significantly reduce the complexity and permanently allow the child tax credit to offset regular income tax liability without considering any alternative minimum tax. *

James M. Hopkins is a professor at Morningside College in Sioux City, Iowa. The author would like to acknowledge the help of Troy J. Hopkins and Ryan Preston in preparing this article

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