ARPA expands tax credits for families

The American Rescue Plan Act (ARPA)¹ increased several tax credits to extend financial aid to qualifying taxpayers and allow additional taxpayers to benefit from them. Chief among them are the child tax credit (CTC) and the child and dependent care credit (CDCC). These enhancements to the CTC and CDCC — including their full refundability — are temporary, currently applying to tax year 2021 only.

Child tax credit

In late 2017, the legislation known as the Tax Cuts and Jobs Act² updated the amount of the CTC from $1,000 per qualifying child to $2,000 per qualifying child and expanded its phaseout range for years 2018 through 2025.³ For 2021, ARPA increases the amount of the credit to $3,000 per qualifying child and to $3,600 per qualifying child younger than 6 years old. In reaching the $3,000 (or $3,600) credit amount, ARPA grafts an additional credit of $1,000 (or $1,600) onto the base credit of $2,000 already provided in Sec. 24.⁴ ARPA further provides a separate limitation and phaseout for this additional credit. The basic differences between the CTC with and without ARPA are summarized in the chart "CTC Changes" (below).

A two-step phaseout

The phaseout of the $2,000 CTC base credit⁵ for tax year 2021 remains much the same as before ARPA. The $2,000 credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income (MAGI) over the applicable thresholds of $400,000 (married filing jointly (MFJ)) and $200,000 (all other filing statuses). The base $2,000 credit is phased out to $0 when MAGI exceeds $439,000 ($239,000 for others).

The phaseout of the additional $1,000 (or $1,600) credit begins when taxpayers' MAGI exceeds $150,000 (MFJ), $112,500 (head of household (HH)), and $75,000 (others).⁶ Thus, taxpayers filing jointly with MAGI of less than $150,000 are entitled to the full credit with no phaseout in 2021.This additional credit amount applies first and is also reduced by $50 for every $1,000 of MAGI over the applicable thresholds.

Example 1: Z and T are married and file jointly in 2021. They have one qualifying 2-year-old child and $175,000 of MAGI. Of the additional $1,600 credit, $1,250 is phased out ([($175,000 - $150,000) ÷ $1,000] × $50), as their MAGI exceeds the $150,000 threshold. None of the base $2,000 credit is subject to phaseout, as their MAGI is less than $400,000. Z and T are entitled to a $2,350 CTC ($350 + $2,000).

Z and T's CTC under identical facts for 2020 would be $2,000.

The additional credit amount of $1,000 for children over age 5 is phased out to $0 when MAGI exceeds $169,000 ($131,500 for HH and $94,000 for others). If the additional credit amount is for a child younger than age 6, the $1,600 additional credit amount is fully phased out once MAGI exceeds $181,000 for MFJ ($143,500 for HH and $106,000 for others).

Example 2: Z and T are married and file jointly in 2021. They have one qualifying 2-year-old child and $185,000 of MAGI. For the additional credit, all of the potential $1,600 is phased out, as their MAGI exceeds $181,000. None of the base credit is subject to phaseout, as their MAGI is less than $400,000. Z and T are entitled to a $2,000 CTC ($0 + $2,000).

For higher-income taxpayers — MFJ taxpayers with MAGI over $400,000 ($200,000 others), the base credit amount of $2,000 phases out. The phaseout is complete once MAGI exceeds $439,000 for MFJ ($239,000 for others).

Example 3: Z and T are married and file jointly in 2021. They have one qualifying 2-year-old child and $425,000 of MAGI. For the potential additional credit, all $1,600 is phased out, as their MAGI exceeds $181,000. The base ($2,000) portion of the credit is also subject to phaseout, as their MAGI exceeds $400,000. The phased out amount is $1,250 ([($425,000 - $400,000) ÷ $1,000] × $50). Z and T are entitled to a $750 CTC ($0 + $750).

Credit fully refundable

Before and after 2021, the CTC is only partially refundable, to the extent of 15% of the taxpayer's earned income in excess of $2,500. An alternative calculation is employed where there are more than two qualifying children.⁷ The maximum refundable credit for 2020 and after 2021 is $1,400 per qualifying child.⁸ For 2021, ARPA makes the CTC fully refundable for a taxpayer with a principal place of abode in the United States for at least one-half of the tax year (either spouse, for MFJ taxpayers) or is a bona fide resident of Puerto Rico, and includes U.S. armed forces members stationed outside the United States.⁹

Advance periodic payments

Moreover, to make this credit available to taxpayers as soon as possible, ARPA directs the IRS to establish a system for advance periodic payments of the 2021 credit to taxpayers.¹⁰ Eligible taxpayers may receive advance payments of up to half of their otherwise allowable 2021 credit during the latter half of 2021, based upon their 2019 (or 2020, if filed) tax return, and may claim any remaining eligible amount on their 2021 tax return. Taxpayers who receive advance payments in excess of their allowable 2021 CTC must increase their 2021 tax liability by the excess, except in certain circumstances for taxpayers with MAGI below specified modest thresholds meeting safe-harbor specifications.¹¹ Additional rules apply to taxpayers who reside in U.S. territories.¹²

Sec. 7527A(c) requires the IRS to establish an online information portal through which taxpayers may elect out of advance payments of their CTC and may update their number of qualifying children, marital status, and significant changes to their taxable income for purposes of the advance payments.

Other ARPA features for 2021 expanding the CTC include that a qualifying child includes 17-year-olds while, in other years, a qualifying child must be under 17.¹³ In all years through 2025, including 2021, the $500 partial credit for certain other dependents, including children who are full-time students between the ages of 18 and 24, remains available.

Child and dependent care credit

The CDCC allows taxpayers a credit for expenses paid for care of one or more qualifying individuals so that the taxpayer may work or seek employment.¹⁴ Many aspects of the CDCC remain unchanged by ARPA, including:

• The taxpayer and spouse must have earned income to claim the credit;¹⁵
• A spouse who is a full-time student or a qualifying individual incapable of self-care may have deemed earned income;¹⁶
• Qualifying expenses must be reduced by amounts excluded from gross income under a dependent care assistance program;¹⁷ and
• Married taxpayers must file jointly.¹⁸

Also, as previously, qualifying expenses exclude those paid to the taxpayer's spouse, parent, someone who may be claimed as a dependent on the taxpayer's tax return, and the taxpayer's children under the age of 19 (regardless of dependency exemption status).¹⁹ Qualifying individuals remain defined as including the taxpayer's qualifying child under age 13 or a spouse or dependent who lived with the taxpayer for more than half the year and was physically or mentally incapable of self-care.²⁰

However, amendments to Sec. 21 by ARPA Section 9631 expand and enhance the CDCC in meaningful ways so that many taxpayers may experience greater tax savings, although high-income taxpayers may lose the ability to claim this credit. Notably, as with the CTC, the changes enacted in ARPA for the CDCC are for 2021 only. The main differences between the CDCC with and without ARPA are summarized in the chart "CDCC Changes" (below).

Before and after 2021, the applicable percentage of qualifying expenses for the credit begins at 35%, with a maximum amount of qualifying expenses allowed of $3,000 ($6,000 for two or more qualifying individuals). The most recent previous increase in maximum qualifying expenses occurred in 2003.²¹

Higher credit percentage and qualifying expense ceiling

For 2021, ARPA raises the initial credit percentage to 50% and expands the maximum amount of qualifying expenses to $8,000 ($16,000 for two or more qualifying individuals). Thus, the maximum amount of the credit available rises from $1,050 ($2,100 for two or more qualifying individuals) to $4,000 (or $8,000).²²

For many taxpayers before and after 2021, the credit's phaseout (in the same format since 2003) renders the CDCC benefit nominal. The applicable percentage of qualifying expenses decreases from 35% (at an AGI of $15,000) to 20% (for AGIs over $43,000), with a decrease in the applicable percentage of one point for every $2,000 increase in AGI. This phaseout, when combined with the limit on qualifying expenses, means that taxpayers with an AGI over $43,000 and qualifying expenses of $3,000 or more are limited to a credit of $600 for the cost of care for one child.

ARPA provides a two-tiered phaseout scheme for 2021. For taxpayers without a high income (an AGI no greater than $400,000), the applicable percentage begins at 50%, and as AGI increases over $125,000, the percentage declines by one point for every $2,000 (or fraction thereof) increase in AGI. Once AGI exceeds $183,000, the percentage plateaus at 20% (until, as noted below, for high-income taxpayers, it phases out further to 0%).

Example 4: H and M file jointly, have an AGI of $100,000, and pay $4,500 in qualified expenses in 2020 for the care of their child, who is a qualifying individual. H and M are entitled to a CDCC of $600 (20% × $3,000). In 2021, with the same AGI and qualifying expenses, H and M's CDCC is $2,250 (50% × $4,500).

Example 5: H and M file jointly, have an AGI of $150,000, and pay $4,500 in qualified expenses in 2020 for the care of their child, who is a qualifying individual. H and M are entitled to a CDCC of $600 (20% × $3,000). In 2021, with the same AGI and qualifying expenses, H and M's CDCC is $1,665 (37% × $4,500).

The credit rate remains 20% for taxpayers with an AGI between $183,000 and $400,000.

Example 6: H and M file jointly, have AGI of $200,000, and pay $4,500 in qualified expenses in 2020 for the care of their child, who is a qualifying individual. H and M are entitled to a CDCC of $600 (20% × $3,000). In 2021, with the same AGI and qualifying expenses, H and M's CDCC is $900 (20% × $4,500).

For high-income taxpayers, an additional phaseout begins at 20%, with the percentage falling by one point for every $2,000 by which AGI exceeds $400,000. Essentially, for taxpayers with an AGI over $438,000, ARPA provisions prohibit taking a CDCC in 2021.

Example 7: H and M file jointly, have an AGI of $450,000, and pay $4,500 in qualified expenses in 2020 for the care of their child, who is a qualifying individual. H and M are entitled to a CDCC of $600 (20% × $3,000). In 2021, with the same AGI and qualifying expenses, H and M's CDCC is $0 (0% × $4,500).

CDCC also is refundable

Notably, the CDCC is refundable for 2021 under ARPA. Though not subject to advance payment as for the CTC, CDCC refundability will benefit taxpayers who were otherwise unable to realize a benefit because of its prior classification as nonrefundable.

A dramatic change

ARPA provisions dramatically changed both the CTC and CDCC, in addition to directing the IRS to establish an online information portal before July 1 to facilitate advance payments of the CTC. The introduction of these changes challenges IRS readiness and occurs at a time when IRS employees are working an active filing season with 20% fewer employees than in 2010. In public comments about IRS preparedness, informed observers note the Service is working to ready itself for these changes, despite repeated budget cuts and hiring freezes in the past. ARPA provides additional funding to the agency, including more than $1.4 billion to modernize its IT systems.²³ It is important to emphasize that the changes in both of these credits are allowed only for the tax year 2021 unless amended further. Tax planning should consider the temporary nature of these changes and optimize their use in tax year 2021. Tax professionals should be prepared to facilitate clients' use of the credits and advance payment of the CTC during the latter half of 2021.

Footnotes

¹American Rescue Plan Act, P.L. 117-2.

²P.L. 115-97.

³Sec. 24(h).

⁴ARPA, §9611(a), adding Sec. 24(i).

⁵Secs. 24(b) and 24(h)(3).

⁶Sec. 24(i)(4)(B).

⁷Sec. 24(d).

⁸Sec. 24(h)(5).

⁹Secs. 24(i)(1) and 32(c)(4).

¹⁰Sec. 7527A. In Rev. Proc. 2021-24, the IRS provided procedures for eligible taxpayers who are otherwise not required to file a 2020 federal income tax return to receive advance CTC payments.

¹¹See Sec. 24(j)(2).

¹²Sec. 24(k).

¹³Secs. 24(i)(2) and (c)(1).

¹⁴Sec. 21.

¹⁵Sec. 21(d)(1).

¹⁶Sec. 21(d)(2).

¹⁷Sec. 21(c), flush language.

¹⁸Sec. 21(e)(2).

¹⁹Sec. 21(e)(6).

²⁰Sec. 21(b)(1).

²¹For tax years beginning after Dec. 31, 2002, by §204(a) of the Economic Growth and Tax Relief Reconciliation Act of 2001, P.L. 107-16.

²²Sec. 21(g).

²³Along with administering recovery rebate advance payments and providing taxpayer assistance; see ARPA, §9601(d)(1).