Congress Makes Changes to Popular Tax Credits

Congress gave taxpayers good news when it permanently extended various expired tax provisions in the middle of December (Consolidated Appropriations Act, 2016, P.L. 114-113). This permanency gives taxpayers and practitioners a better ability to plan for these tax breaks without the annual worry of wondering whether they will be extended and for how long.

However, buried in the good news of the extensions were some other, less-publicized changes that affect the child tax credit, the American opportunity credit, and the earned income tax credit (EITC). These changes include new restrictions, new penalties, and new due diligence requirements for practitioners.

Child tax credit

Sec. 24 provides a $1,000 tax credit to a taxpayer whose income is below certain thresholds for each of the taxpayer’s qualifying children under age 17. The credit is generally nonrefundable, meaning that the credit cannot exceed the taxpayer’s tax liability. However, Sec. 24(d) makes portions of the credit refundable. This refundable credit is commonly referred to as the additional child tax credit, and it is calculated using a percentage of the taxpayer’s earned income for the year (15% of the excess of taxable earned income over $3,000). A separate limitation applies to taxpayers with three or more qualifying children.

Before the new legislation, the $3,000 amount for calculating the refundable portion of the credit was scheduled to increase to $10,000, adjusted for inflation, in 2018. Now, the threshold amount for determining whether a taxpayer is eligible for the refundable (or additional) Sec. 24 child tax credit is permanently set at $3,000 (not indexed for inflation), which has been the threshold since 2009.

Retroactive claims: One change the legislation makes is to prohibit retroactive claims of the child tax credit. It does this by preventing taxpayers from amending a return (or filing an original return) to claim the credit for any prior year in which the taxpayer or the qualifying child did not have an individual taxpayer identification number (ITIN). This means that taxpayers cannot file returns claiming the credit using an ITIN issued after the year for which the credit is being claimed. The effective date of this provision allows taxpayers to file their 2015 returns without regard to this rule if the returns are timely filed (Section 205 of the Act).

New penalties: Before the new legislation was enacted, there was no penalty for taxpayers who recklessly or fraudulently claimed the child tax credit. Now, the rules that already applied to false claims for the EITC also apply to the child tax credit. Individuals who fraudulently claimed the credit are barred from claiming the credit for 10 years. If they are found to have claimed the credit with reckless or intentional disregard of the rules, the bar applies for two years (Sec. 24(g) as amended by Section 208(a)(1) of Division Q of the Act).

IRS claim processing: The Act gives the IRS math error authority, which allows it to disallow improper credits without a formal audit if the taxpayer claims the child tax credit in a period in which he or she is barred from doing so (Sec. 6213(g)(2)(P)). For taxpayers claiming the additional child tax credit after Dec. 31, 2016, the IRS will have additional time to review the refund claim and will not be required to pay the refund before the 15th day of the second month following the close of the tax year (Sec. 6402(m)).

Due diligence: Effective for tax years beginning after Dec. 31, 2015, return preparers will be subject to due-diligence requirements for returns that claim the child tax credit, much as they are currently subject to for returns that claim the EITC. For the EITC, those requirements include submitting a completed checklist with the return; completing a prescribed worksheet; maintaining certain records for three years that document their due diligence; and not knowing, or having reason to know, that any information that was used to determine if the taxpayer is eligible to claim the credit or to compute the amount of the credit is incorrect. What the exact child tax credit due diligence requirements will be is, as yet, unknown: The IRS was given authority to issue regulations imposing due diligence requirements for returns claiming the child tax credit, but has not yet done so. The penalty for failure to comply with the due diligence requirements will be $500 for each failure (Sec. 6695(g)).

American opportunity tax credit

The American opportunity credit permits taxpayers to claim a credit of up to $2,500 for each eligible student for qualified educational expenses (Sec. 25A). The credit phases out when modified adjusted gross income exceeds certain amounts.

Before legislation was enacted in 2009, the credits for educational expenses were called the Hope credit and the lifetime learning credit. In 2009, the American Reinvestment and Recovery Act, P.L. 111-5, renamed the Hope credit the American opportunity credit. The new credit was originally to be effective from 2009 to 2017 (Sec. 25A(i)). The Act makes the credit permanent.

Reporting requirements: Taxpayers claiming the American opportunity credit are now required to report the employer identification number of the educational institution to which the taxpayer makes qualified payments under the credit (Sec. 25A(i)(6)(C)). Also note that the Act made changes to the reporting requirements for higher education institutions, which will be required to report only qualified tuition and related expenses actually paid on Form 1098-T, Tuition Statement, rather than being allowed to choose between reporting amounts actually paid or amounts billed. Both of these provisions are effective for expenses paid after Dec. 31, 2015, for education furnished in academic periods starting after that date.

Retroactive claims: Similar to the child tax credit, the law prohibits an individual from retroactively claiming the credit by amending a return (or filing an original return) for any prior year in which the individual or a student for whom the credit is claimed did not have an ITIN (Secs. 25A(i)(6)(A) and (B)). This means that taxpayers cannot file returns claiming the American opportunity credit using an ITIN issued after the year for which the credit is being claimed. The effective date of this provision allows taxpayers to file their 2015 returns without regard to this rule if the returns are filed by the due date (Section 206(b)(2) of the Act).

New penalties: Again adding a provision that previously applied only to the EITC, individuals are barred from claiming the American opportunity credit for 10 years if they fraudulently claim the credit, and for two years if they are found to have claimed the credit with reckless or intentional disregard of the rules (Sec. 25A(i)(7)).

IRS claim processing: The IRS is given math error authority, which allows it to disallow improper credits without a formal audit if the taxpayer claims the credit in a period in which he or she is barred from doing so (Sec. 6213(g)(2)(Q)).

Due diligence: Similar to the new due-diligence requirements under the child tax credit, effective for tax years beginning after Dec. 31, 2015, return preparers will be subject to due-diligence requirements for returns that claim the American opportunity credit. And, as with the child tax credit, what the due-diligence requirements relating to the American opportunity credit will be is unknown: The IRS was given authority to issue regulations imposing due diligence requirements for returns claiming the American opportunity credit, but has not yet done so. The penalty for failure to comply with the due diligence requirements will be $500 for each failure (Sec. 6695(g)).

Earned income tax credit

The EITC grants a refundable credit to low- or moderate-income taxpayers with earned income. The amount of the credit is the taxpayer’s earned income (up to the statutory maximum amount as adjusted for inflation) multiplied by the credit percentage. The maximum earned income amount and the credit percentage that apply to a taxpayer are based on the taxpayer’s number of qualifying children. The credit is phased out for taxpayers with adjusted gross income or, if greater, earned income, over the applicable credit phaseout threshold amount, which is also based on the number of the taxpayer’s qualifying children.

Higher credit amount: The credit rate is 7.65% for taxpayers with no qualifying children, and it increases to 34% for one qualifying child, 40% for two qualifying children, and 45% for three qualifying children. The 45% credit for three qualifying children was originally a temporary provision that was scheduled to expire in 2018. Instead, the Act made the 45% credit permanent.

In 2009, the credit phaseout threshold amounts for married couples filing a joint return were increased by $5,000, with an annual inflation adjustment, over the threshold amounts for other filers, for the years 2009 through 2017. After 2017, the increase in the threshold amounts for married taxpayers filing jointly was scheduled to expire. The Act made the $5,000 increase to the credit phaseout threshold amounts for married taxpayers filing jointly permanent and continues the annual inflation adjustments for years after 2015.

Retroactive claims: Similar to the other credits described above, the Act prevents retroactive claims of the EITC by prohibiting individuals from claiming the credit on an amended return (or original return) for any prior year in which the individual did not have a valid Social Security number. This means that taxpayers cannot file returns claiming the credit using a Social Security number issued after the year for which the EITC is being claimed. The effective date of this provision allows taxpayers to timely file their 2015 returns without regard to this rule. (Unlike the other credits, taxpayers must have Social Security numbers to claim the EITC, not merely an ITIN (Sec. 32(m)).)

IRS claim processing: For taxpayers claiming the EITC after Dec. 31, 2016, the IRS will have additional time to review the claim and will not be required to pay the refund before the 15th day of the second month following the close of the tax year (Sec. 6402(m)).

Sally P. Schreiber is a Tax Insider senior editor.